Home equity loans can feel like a financial lifeline since they offer large sums of cash at relatively low interest rates. But behind the appeal is a very real series of risks that every homeowner should understand before tapping into their home’s value.
First, your home is on the line. This is the biggest risk because your house actually secures the loan. If you fall behind on payments, you’re not only hurting your credit but you could actually lose your home to foreclosure. It’s a debt with high stakes.
Next, it is common for easy money to lead to overspending. Because home equity loans offer lump sums, it’s tempting to use them for wants, not needs such as vacations, new cars, or luxury upgrades. But if those purchases don’t increase your home’s value or income, you’re taking on long-term debt with little return.
Also, new fixed payments and interest costs can become untenable. Unlike flexible lines of credit, home equity loans come with set monthly payments. Often times, the interest rate on the loan can change (increase) over time as well. If your income changes due to job loss, retirement, or unexpected expenses, those payments don’t go away.
Finally, the market value of your home can drop. If home prices fall, you might owe more than your home is worth. That’s called being “underwater,” and it can make selling or refinancing nearly impossible, especially during a downturn.
These items are not meant to be an exhaustive list of risks, but rather a summary of things to consider. Overall,a home equity loan isn’t inherently bad but it’s not risk-free. If you go this route, use it for the right reasons, with a clear plan to repay it. I also feel strongly that you should be prepared for payment increases in the event that interest rates go up. Otherwise, what starts as a solution could become a very big problem.