
During the pandemic, home prices surged as massive influxes of buyers, low mortgage rates and limited inventory allowed those prices to climb virtually unchecked. That led to record-breaking equity gains for homeowners, making products such as home equity loans and lines of credit, or HELOCs, attractive options.
Today, the market is seeing price growth start to level off and, in some cases, even decline. “But, there is still plenty of equity in American houses,” says Vikram Gupta, head of home equity at PNC Bank.
But before you take out a home equity loan or HELOC, you need to be certain you understand the risks associated with each of them.
Read on to learn what the specific financial risks are when it comes to HELOCs and home equity loans and how you can avoid them.
How do home equity loans and HELOCs work?
Home equity loans and HELOCs allow you to access your home’s equity without changing your primary mortgage’s interest rate. When you borrow with a home equity loan or HELOC, you use the difference between your home’s value and what you owe on your mortgage as collateral. Because they’re secured loans, you can often get a more competitive rate with a home equity loan or HELOC than with, say, a personal loan. But they come with major risks, such as home foreclosure, that other types of financing don’t involve.
Here’s how the two products work:
With a home equity loan, you borrow a set amount of money and pay it back over time, typically at a fixed interest rate. That fixed interest rate means your monthly payment will be constant over the term of your loan. In a rising rate environment, it may be easier to factor a fixed payment into your budget.
HELOCs, on the other hand, offer a revolving line of credit to tap as needed. You’ll only pay interest on the cash you’ve borrowed, but, usually, at a variable rate. That means your monthly payment is subject to change as rates rise.
Most homeowners use home equity loans for major life expenses such as home renovations and to consolidate other kinds of debt. As long as you have built up at least 15% to 20% equity in your home, lenders will typically allow you to borrow up to 85% of your home equity.
What are the risks of home equity loans and HELOCs?
Both of these means of drawing on one’s home equity can be great financial tools. However, they do come with significant risks.
You can lose your home.
The biggest downside to any type of home equity loan is that you must use your house to secure the loan. When using your home as collateral to secure a loan, the bank or lender can take possession of your house to repay themselves if you miss payments or default on your equity loan for any reason.
“You put up your home as collateral for both a home equity loan and a HELOC, which means that if you fail to make payments on either, you could lose your home through foreclosure,” says Robert Heck, VP of mortgage at Morty, an online mortgage marketplace.
For most people, losing their house is a much more significant consequence than a lower credit score, which is why it’s vital to carefully consider whether you can manage paying back a home equity loan over an extended period of time.
Variable interest rates may break your budget.
With HELOCs, one downside to consider is that they have variable interest rates, which means you won’t have consistent monthly payments. What you’re required to pay each month will increase or decrease with interest rate trends overall. HELOC rates are impacted by the prime rate, which is currently at 8.0%. The prime rate is the interest rate banks use to determine lending rates, as well as economic policy set by the Federal Reserve. The Fed has hiked rates nine times since March 2022 and is likely to increase further or hold at an elevated position for longer.
That means it’s likely your HELOC payments will increase in the near future in our current economic environment. So it’s critical to make sure your income can comfortably accommodate the fluctuations in your monthly payments.
Home equity loans, on the other hand, have fixed interest rates. In a rising interest rate environment, like the one we’re experiencing today, that can prove beneficial for homeowners who won’t have to worry about their rates -- and therefore their payments -- increasing.
An increase in debt can lower your credit score.
A HELOC is a revolving line of credit that functions like a credit card, so maintaining a high balance over time can lower your credit score. While one benefit of a HELOC is that you can make interest-only payments during the initial draw period, once your repayment period begins, your monthly payments will jump because you’ll also begin paying back the principal.
Because home equity loans don’t function as a line of credit you can continually access, there’s less risk to your credit score. However, whenever you take out a loan, your credit score will be affected in the short term, but it will recover as the loan ages and you pay it off.
Regardless, make sure you can manage such an increase comfortably within your budget. Use Bankrate’s HELOC calculator or home equity loan calculator to determine whether your monthly budget can handle a second mortgage payment. Making consistent and on-time payments for your HELOC can impact your credit score positively, as well.
Falling home values can limit your loan.
Home price growth is starting to slow but home values are still strong, thanks to record gains during the pandemic. That’s good, until a recession or other cataclysmic economic event causes home values to drop again, in which case, borrowing against the equity in your home could backfire.
“The ability to borrow is based on the amount of excess equity you have in your house,” Gupta says. “The excess equity in your house is determined by that home price minus all existing current debt on the house.”
When your outstanding loan balance ends up being higher than the value of your home, your lender has the option to freeze or reduce your line of credit since your home can no longer serve to secure the loan. Having a larger loan balance than what your house is worth is known as negative equity, or when you are “upside down” on your mortgage.
How to protect yourself from the risks of home equity loans and HELOCs
If you’re planning on tapping into your home’s equity, it’s key to have a strategy for how you’ll use and pay back the money you borrow. Many experts say there’s potential for a recession in 2023. So, you want to make sure you have room in your budget in case you face job or income loss.
Experts also caution against treating home equity loans, and particularly HELOCs, like an ATM or credit card. Remember, if you default on your payments, you risk losing your home.
Here are some other ways to protect yourself from the risks of home equity loans and HELOCs:
- Consult with a financial adviser: In general, it’s prudent to consult with a financial adviser when making significant financial decisions such as taking out a loan against your home. Financial professionals can help you figure out whether such a loan makes sense for your long-term financial goals.
- Keep track of or make a budget: No matter what, it’s crucial to model out different versions of your budget to make sure you can afford your monthly payments even if your financial circumstances change. Determine what the maximum loan amount you can cover is if there is an interest rate increase or a life event like a job loss so that you’ll be able to keep making payments without interruption, no matter what macro and micro economic factors arise.
- Monitor your credit score: As always, keep track of your credit and sign up for a free weekly credit report to make sure your credit score stays healthy, as you’ll likely be carrying a balance for years with a home equity loan or HELOC.
- Convert a HELOC into a fixed-rate HELOC: If interest rates continue to rise, which experts expect, one option is converting a HELOC into a fixed-rate HELOC or home equity loan so you can fix your interest rate and keep your payments consistent.
The bottom line
Home equity loans and HELOCs come with the risk of losing your house if you miss multiple payments. During times of economic uncertainty, it’s critical to make sure your monthly budget can handle fluctuations to your second mortgage payment if your payments increase. As a homeowner, you have to weigh the pros and cons of collateralizing a loan with your property. And as with any loan, it’s always smart to shop around with multiple lenders and compare rates and fees to make sure you’re receiving the most favorable terms available.