Home equity hazards: The risks of tapping your property’s value

With housing prices climbing, home equity is reaching near-record highs: The average mortgage-holding homeowner’s stake is worth nearly $305,000, according to property data analyst CoreLogic. That’s an average gain of $28,000 in the first quarter of 2024 over Q1 2023 alone.

And given inflation’s ongoing bite, now could be an ideal time to tap that equity for some quick cash. Many folks are doing just that. In fact, homeowners took out almost four times the amount of home equity lines of credit (HELOCs) in the first quarter of 2024 compared to the early part of 2021, according to a report from ATTOM.

Borrowing against your home’s equity can be smart if you’re confident you can handle the payments and plan to use the money for home improvements that increase your property’s value. But before you dive in, there are a few important things to consider. While all loans come with some level of risk, home equity financing is a type of secured debt—secured by your home, to be precise—which means you should approach it with an additional layer of caution.

Here are the hazards of tapping your home equity and how to avoid (or at least minimize) them.

Risks of home equity loans

There are two main types of loans that use your home as collateral: home equity loans and home equity lines of credit (HELOCs). Here are their risks.

Your home is on the line

The stakes are higher when you use your home as collateral for a loan. Unlike defaulting on a credit card — whose penalties amount to late fees and a lower credit score — defaulting on a home equity loan or HELOC could allow your lender to foreclose on your home. There are several steps before that would actually happen, but still, it’s a possibility.

Before taking out a home equity loan, make sure you understand all the terms and conditions. Compare your household income to your monthly expenses to see if you can really afford the payments. Remember: If you’re still carrying a mortgage, you will be responsible for paying off two loans.

Home values can change

With elevated mortgage rates and high home prices constantly in the news, the idea of a drop in property values seems hard to imagine nowadays. Yet it can happen, and even has in a few overheated real estate markets around the country.

When you tap into your home equity, you’re essentially reducing your ownership stake in your home. This can be a real problem if property values fall, as you might end up with very little equity or even owe more than your home is worth — a situation known as negative equity. Being underwater (as it’s also known) can impede your ability to sell your home or refinance your mortgage.

Interest rates can rise with some loans

While loan terms vary by lender and product, HELOCs generally have adjustable rates, which means that payments increase as interest rates rise.

“The interest rate on a home equity line of credit is often tied to the prime rate, which will move up if there’s inflation or if the Fed raises rates to cool down an overheating economy,” says Matt Hackett, chief operating officer at mortgage lender Equity Now.

Because interest rates are unpredictable, HELOC borrowers could pay much more than they originally signed up for—especially if rates rise quickly, as they did in 2022. In the worst cases, monthly payments could become unaffordable.

Home equity loans, on the other hand, typically have fixed interest rates, so you’ll know exactly how much your monthly payment will be for the entire loan term.

Payments could skyrocket

While you can usually pay back whatever you borrow at any time, many HELOCs allow interest-only payments during their draw period (when you actually access the funds). Tempting as that is, if you only make these minimum payments, you won’t make any progress in paying down your outstanding balance.

After the end of the draw period, which is typically 10 years, the HELOC’s repayment period begins: Borrowers can no longer use the credit line, but must start repaying both principal and interest. If you withdrew a large amount during the draw period and only made minimum payments, you might experience sticker shock once the principal balance is added to your monthly bill.

“A lot of people think, ‘I’m gonna take out a HELOC, it will be interest-only and cheaper in the beginning,’” says Yechiel Zeilingold, a loan officer with FM Home Loans, a mortgage lender based in Brooklyn, New York. “Then 10 years down the line, everyone may have a hard time coming up with that money.”

Your credit score can drop

Opening a home equity loan can also affect your credit score. Your credit score is made up of several factors, including how much of your available credit you’re using.

Depending on your financial situation, a large home equity loan to your credit report can negatively impact your credit score by increasing the amount of available credit you’ve utilized. That could make it harder to qualify for other loans in the immediate future. For example, getting a home equity loan right before buying a car could mean a higher interest rate on the auto loan (because your score is lower, making you look less creditworthy) or even a rejection entirely.

In the long run, having a home equity loan and making regular monthly payments can strengthen your credit by showing you can handle long-term debt responsibly. Just be aware of the short-term drop you’ll likely see.

Your debt load will increase

Any loan increases your debt burden and the demands on your income, of course. But by tapping into your home’s equity, you’re essentially depleting your ownership stake — transforming a valuable asset into a costly obligation.

As your debt levels rise, so does your debt-to-income ratio (DTI). A higher DTI ratio makes you seem less creditworthy, impacting your ability to qualify for new loans or credit cards (or for the best rates). So, before tapping into your home equity, proceed with caution.

When to avoid a home equity loan

While you can use home equity loan funds for anything, that doesn’t mean you should. A home equity loan could be a good idea if you use the funds to make home improvements or consolidate debt with a lower interest rate. “A lot of people think it’s a band-aid situation where they can wrap their debt into one monthly [HELOC] payment,” says Christy Bunce, president of New American Funding, a mortgage lender based in California. “It’s not like they’re getting rock-bottom rates, but they can lower their monthly debt.” And once interest rates fall, those same homeowners may opt for a cash-out refinance, pay off that HELOC and wrap it into their primary mortgage, she adds.

However, it is a bad idea if it will overburden your finances or only serve to shift debt around. If you’re thinking of taking out a home equity loan, it’s best to avoid using it in the following scenarios.

To meet everyday expenses

It’s generally not a good idea to resort to a home equity loan if you need funds to help resolve day-to-day money shortfalls in your household or living budget, says Steve Sexton, financial consultant and CEO of Sexton Advisory Group, based in Temecula, Calif.

After all, a home equity loan still needs to be repaid, and failure to keep up with payments could send you deeper into debt. “If you’re hoping it will help your cash-flow problems, it will likely do the opposite if you don’t have a structured plan to pay back the loan,” says Sexton.

To buy a car

Using home equity loans to purchase a new car is not wise. Sexton describes this as simply moving debt from one place to another without solving the root financial issues, typically poor spending habits or overspending.

To pay for a vacation or holiday purchases

If taking out a loan to pay for a vacation would stretch your monthly budget — and put your home at risk — it’s better to hold off on the loan and start a vacation-specific savings fund instead. The same goes for holiday expenses. While interest rates on home equity loans are lower than credit cards or personal loans, using the equity in your home to shop or entertain during the festive season is very dangerous.

“Using home equity loans to fund leisure and entertainment indicates you’re spending beyond your means,” says Sexton. “Using debt to fund your lifestyle only exacerbates your debt problem.”

To invest in real estate (or anything else)

Investing is always a laudable activity, but going into debt to invest is debatable. Real estate is particularly speculative and, more importantly, highly illiquid, meaning it cannot quickly be sold without a loss in value. Even if your real estate investment goes well, it can take years to realize any appreciation, and it will take time to get your money back out in order to repay your home equity loan.

The one exception might be to use home equity to buy an adjacent property or lot, as the extension arguably enhances your home’s value.

To pay for college

This one is not so much a total avoid as a consider-it-carefully. True, going to college can be considered an investment in terms of skills and careers. And using home equity loans can be a smart strategy, especially HELOCs, which are tailor-made for expenses incurred in installments over a long time period. You can just withdraw what you need for that year’s or that semester’s tuition and only incur interest on that particular amount. You or your child can also start paying it back right away, rather than being hit with a mountain of debt after graduation.

But there are other ways to pay for college that don’t require risking losing your home. What’s more, interest rates on federal student loans are lower than those on HELOCs and home equity loans.

How to protect yourself from the risks of home equity loans and HELOCs

If you do take the home equity loan plunge, go about it intelligently.

Don’t borrow more than you need

Don’t just automatically tap your equity to the max. Try to calculate exactly how much you’ll need — perhaps with a bit extra, depending on the expense — and limit your draw to that. Before you apply, it’s a good idea to crunch numbers with a financial advisor to see how much you can afford to borrow and comfortably repay each month

Create and stick to a budget

When you get your home equity loan or HELOC, it’s easy to feel like you have a huge cash pool. That makes it easier to spend superfluously. Having a large line of credit in particular can be tempting — like a giant credit card.

When you get your loan, create a new budget — one that includes your new loan payment so you can make good progress on paying down the balance. If you opted for a HELOC, make sure that the budget includes payments for both interest and the loan itself. Even if interest-only payments are allowed, paying off the principal during the draw period can save you a lot of money (in smaller interest charges) and avoid a nasty payment spike when the draw period ends.

Remember: “It’s a mortgage. It’s not a credit card. It’s not a personal loan,” says J.R. Younathan, vice president, state production manager, California Bank and Trust, a California-based HELOC lender. You want to be as diligent in paying it as you would with your primary mortgage.

That’s not to say a HELOC can’t work as a reserve fund. If you can afford the yearly fee to keep the line of credit open, Younathan says, “Leave it there and you don’t have to touch it” — until an emergency or an extra expense arises. According to Experian, about half of borrowers keep their lines of credit at a 0-percent balance for future needs.

Refinance your HELOC into a fixed-rate HELOC

If you sign up for a HELOC with an adjustable rate, you can always consider converting to a fixed rate during your draw period or after it ends (assuming the lender allows it — another thing to look for when comparing offers). Many lenders offer fixed-rate HELOCs and HELOC conversions. This gives you a chance to pay off or pay down your balance while the rate is locked.

Or you could refinance your HELOC into a fixed-rate home equity loan. That will protect you from unexpected shifts in interest rates, which can increase your monthly payments. Just be sure to read the fine print of your loan to make sure there isn’t a prepayment penalty.

Monitor your credit score

Keep an eye on your credit score and how your home equity loan impacts it. Adding a new, large debt to your report will likely drop your score in the short term. Keep watching your score to see how it changes as you make payments or draw additional funds from your HELOC. If it drops significantly, consider pausing HELOC withdrawals or stepping up your efforts to pay off the loan.

Shop around for the best rates and terms

Don’t settle for the first home equity loan or HELOC offer you receive. Compare rates, terms and fees from at least three lenders to ensure you get the best deal. Some lenders waive closing costs for loans of a certain amount or offer promotional rates. Even a small difference in interest rates can translate to significant savings over the life of the loan.

FAQ about home equity loan risks

• Can I use a home equity loan to pay for emergency repairs?

  If your home suddenly needs a plumbing overhaul, a replaced septic system or a new roof, it can be hard to come up with thousands of dollars on short notice. Using a home equity loan to fund emergency repairs can make sense, especially since you are maintaining your home’s value by making the repairs.
  

• Can I use a home equity loan to pay for home improvements?

  You can use a home equity loan to pay for home improvements — in fact, that’s what they’re most commonly used for. Using your home equity to fund renovation projects can make it a better place to live while also boosting the value of your property.
  

• Can I use a home equity loan to buy land to build on?

  Your home equity can be a source of financing to purchase land, whether you’ll build a home on it or not.
  

• Are there any alternatives to a home equity loan?

  When you need to access cash and a home equity loan is not a viable option, there are alternatives. The options include:

  • Personal loan
  • Credit cards
  • Cash-out refinance

• Are there tax implications with a home equity loan?

  If you use a home equity loan to fund improvements to your home, the interest payments you’ve made on the loan may be tax deductible.
  

Bottom line on home equity loan risks

Some home equity lenders tout your ownership stake as a treasure that’s just sitting around, begging to be tapped. But the reality is that home equity loans are just that: loans. They create a debt that must be paid back, and they come with fees and interest, which can ultimately cost you thousands of dollars on top of your initial loan amount.

Still, using home equity as a long-term investment in your home to enhance its worth can still be a sound strategy. Before committing to a home equity loan, consider your budget and compare interest rates, terms and fees from a variety of lenders to see how much it could cost you.