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What Are the Risks of A Home Equity Loan

There is the potential for a lot of excitement and optimism to come with the application-and approval-of a home equity line of credit, and sometimes, the immediately perceived benefits outweigh the risks. So, when considering whether you want to apply for one, take a moment to review the risks and compare options in order to find the best situation for you and your home.

What Is Home Equity and How Does it Work?

Home equity is the value that your house has once its fair market value is assessed by a home inspector and compared with the remainder of what you owe. As with any loan type, there’s a risk you won’t be able to pay it. One of the biggest things to keep in mind with regard to home equity loan risks is the fact that your house is on the line. Your home is used as collateral whether you’re applying for a regular home loan or a HELOC (home equity line of credit). While the two forms of loans vary to certain degrees, the risks are mostly similar, and your house is weighted against the loan.

Chance of Interest Rates Increasing and Bumping up Your Monthly Payments

This is a very real scenario. While during any standard glance at the housing market and establishing where the prime rate is, it’s important to remember that there are multiple things that could go awry and put you in a massively uncomfortable position with your monthly payment. After the Federal Reserve cut rates three times in 2019, they also indicated there weren’t going to be any rate hikes coming up on the 2020 horizon. So it’s safe to say that it’s among the best of times for people interested in taking out home equity loans.

Your House Is On the Line

This reiteration is on purpose and deserves its own subtitle. Your house is on the line, and there’s no reason to jeopardize that. But there’s no reason to fear this fact either, especially if you have decent credit and the amount you’re “taking out” against the equity (or grown value) isn’t too extravagant. Still, it’s a primary factor to consider when weighing the risks and benefits of home equity loans or lines of credit.

Home Equity Can Rise and Fall

The best advice that goes along with this risk is simple: don’t borrow more than you need to. Similar to the reestablishment of rates, there can be changes in the market that upset the order to things such as HELOCs and home equity loans. For instance, there were upsets in the market with the 2008 housing bubble burst, and a lot of people found themselves upside-down after the crash. Simply put, they owed more on their homes than their homes were, at the time, valued. This is a real risk to consider too, as you could end up owing more than the fair market value of your house.

A Couple More Risks To Be Aware Of

In addition to your monthly mortgage payment, you’ll have this one too

Although the payment is reduced, it’s essential to remember that it’s still an additional financial commitment tied to the property. In an ideal scenario, the equity released from such payments could be employed to propel a long-held aspiration forward or to fuel business growth through investments or expanding your reach. Unfortunately, what can sometimes transpire is that instead of wisely investing these funds to benefit your business, they end up accumulating as additional debt. In this situation, there’s also the associated risk of harming your credit score by maxing out your credit line. If you’re exploring alternative approaches to manage your property and finances more effectively, one option to consider is selling a land contract or a lease-purchase agreement. This strategy can help you monetize your assets and secure a steady income stream. It also gives you the flexibility to prioritize other investments with the capital you receive.

Reduction in equity

Equity is technically an inexact number, and although this is the case, it’s still an important notion. If you apply for any other new loans, the overall loan amount is still added to the total borrowed against the property. The more equity you keep available, the more options you’ll continue to have available. If your loans against the equity max out, then note that there won’t be as much wiggle room in terms of value when you want to sell or remortgage to release equity, and you may have to keep the property until you have regrown or the property has increased in value again.

Balloon option

There’s an interest-only option for the first 10 years on a HELOC. During the repayment period in the first 10 years, there’s no principal payment added to the monthly payment. Because there’s no principle, it will need to be repaid during the following 10 years, unless you’re attuned to this fact and consider the math. The interest-only payments will seem lower and manageable, but once the principal is figuring into the loan, the monthly repayment amount can be significantly higher.

During the draw period, where you’re able to access and draw funds out of the account, it makes sense to keep track of how much you’re taking out. Your best option is to make payments that cover both interest and principal. Borrowers who only make minimum monthly payments are at risk of never paying off their loans. It’s best to pay off the balance before the 10-year period is over. A final note on the topic: a HELOC should never be used to finance a lifestyle beyond your means.

Just as there are going to be various home equity options available to homeowners, there are going to be associated risks. If you’re a homeowner with equity in your home who wants to upgrade the kitchen or finance a child’s private school tuition, then take a look at home equity loans and lines and see where you can help along your project or goal. The experts at Rivermark Community Credit Union will be able to clarify any concerns and answer any questions.