What Are the Risks of a Home Equity Loan?
Do you need money for a big expense coming up? It can be as varied as necessary home repairs, such as a new roof; paying for a wedding or an unexpected hospital stay; a lavish vacation; or paying off a student loan. If you have equity in your house, you can use an equity loan to take out money for your own use for … anything!
The equity in your home is a simple calculation. How much is your home worth? How much do you owe on it? Subtract how much you owe from the total amount your home is worth. If your home is worth $250,000 and you owe $150,000 on it, then the equity on it is $100,000.
You want to be absolutely sure that the risks don’t outweigh the benefits of this type of loan, though. Maybe you want that lavish vacation, but your credit card bills are maxed out. Maybe it’s best to focus on the credit cards before the vacation—but you can also use the home equity loan to pay off the credit cards and other bills. Just make sure you don’t let the cards get out of control again.
Here are the major home equity loan risks for you to consider.
Your Home Could Be at Stake
There’s an element of risk here because your home is the collateral. In the absolute worst-case scenario, you can lose your home if you’re unable to make the monthly payments. This is why the lender doesn’t often care what you’re going to use the money for. Since you put the house up as collateral, they can foreclose on it if you’re not able to make payments on it. If you lose your job or if other bills pile up, this could mean the lender takes your home. The lender may also charge late fees for late payments, but that could be the least of your worries.
You’re Taking on More Debt
If you have no other way to pay for essential things—your only car was totaled and there’s no public transportation in your area, or you had a sudden emergency medical expense, or your roof is leaking and needs to be replaced—it may be necessary. You may be given relatively favorable interest rates, but at the end of the day, it’s more debt to add to your name (and your finances). Your monthly payments will increase. There may be more interest to pay. Make sure you can pay that extra amount each month and that you’re aware of how much longer it may take to pay off the first mortgage.
You’ll Still Have to Pay the Closing Costs and Fees
These vary but can be between 2 and 5 percent of the loan amount itself, and there may be an early termination fee if you pay off the loan ahead of schedule. When you speak with a professional at your financial institution, make sure they outline if there are any other costs or fees you can expect. Remember, too, that if you start paying back the balance but can only make the minimum payment, you’re not really making any progress. It’ll be difficult to pay it off that way.
What If You Go Underwater?
If your home’s value declines after you’ve already tapped into your equity, you could end up owing more on your home than what it’s actually worth. This term is also known as being “upside-down” on your mortgage. This was a common occurrence in 2008 during the mortgage crisis, and standards have been changed to try to prevent that type of situation, but it’s still a possibility.
Equity Reduction on Your Home
If you take the equity out of your house, it’s like taking money out of your credit union that you’ve already paid. You can use that money, but in the end, your house may be worth less. If you sell the house in the future, you may walk away with less in your pocket than you’re expecting since you’ve had to pay off two loans instead of one. You’ll also have to pay off additional principal and interest each month, which means it will take a lot longer to pay off the first loan.
The Hit to Your Credit Score
If you make frequent late payments, or if you lose your house due to foreclosure, it can show up on your credit report. Future landlords, car dealerships, or even employers might balk at doing business with you if they see you’ve lost a home. A foreclosure can drop your credit score dramatically, between 85 to 105 points if you had an average score beforehand, or between 140 to 160 points if your score was excellent before the transaction. A foreclosure will stay on your credit report for seven years from the date of the first missed payment.
If you receive a home equity line of credit (HELOC), you’ll have a little more flexibility, but there are still some risks involved. Instead of receiving the money in one lump sum, as with a home equity loan, with a HELOC, you’ll receive a line of credit with an approved amount from which you’ll be able to borrow as needed. This is helpful for times when you’re unsure of the total need, such as when you start up a new business or if you want to remodel the house. You’ll only pay interest on HELOCs on money that’s withdrawn, so if you get a HELOC but never use it, you’ll never pay any interest on it. The (albeit smaller) risk on a HELOC is that the lender can cancel the line of credit, possibly before you’ve used all the money.
We’re always happy to answer your questions. If you’re interested in taking the plunge, and if you think a home equity loan is right for your financial goals, apply online or in-person at a Rivermark Community Credit Union near you, and we can answer any further questions you might have. We have a lot of home-related resources available as well.