What are the risks of HELOCs and home equity loans?

For many homeowners, borrowing from the Equity in your home is an attractive option now, thanks to soaring home values over the past two years. But before you take out a home equity loan or home equity line of credit, you need to be sure you understand the risks associated with home equity loans.

Read on to find out what the specific financial risks are when it comes to HELOC and home equity loans and how you can avoid them.

How does a mortgage loan work?

Home equity loans allow you to borrow money against the equity you have built up in your home and provide you with a lump sum of cash at a fixed interest rate. HELOCs are also equity loans, but they work like a revolving line of credit, which means you can withdraw your money in installments and your interest rate is variable, so your monthly payments will change.

Equity loans are useful and can be cost effective ways to access cash at lower interest rates than other types of loans, such as personal loans or credit cards. For example, home equity and HELOC rates are both below 7% right now, while personal loans have an average interest rate of 10.7%, according to CNET's sister site Bankrate. But they come with major risks, such as foreclosure, that other types of financing do not involve. Most homeowners use home equity loans for major living expenses such as home renovations and to consolidate other types of debt. As long as you have accumulated at least 15% to 20% of the equity in your home, lenders will generally allow you to borrow up to 85% of the equity in your home.

What are the risks of home loans?

You can lose your house.

The biggest disadvantage of any type of home equity loan is that you must use your home to secure the loan. When you use your home as collateral to secure a loan, the bank or lender can take possession of your home to reimburse themselves if you miss payments or fail to repay your equity loan for any reason.

"You're putting your house up as collateral for both a home equity loan and a HELOC, which means that if you don't make payments on either, you could lose your house for sure. foreclosure," says Robert Heck, vice president of mortgages at Morty, an online mortgage marketplace.

For most people, the loss of their home is a much bigger consequence than a decline. credit scorethat's why it's essential to carefully consider whether you can manage the repayment of a home loan over a long period of time.

Variable interest rates can break your budget.

With HELOCs, one drawback to consider is that they have variables interest rate, which means you won't have regular monthly payments. What you owe each month will go up or down depending on general interest rate trends. HELOC rates are affected by the prime rate, which is currently 5.5%. The prime rate is the interest rate used by banks to determine lending rates, as well as the economic policy set by the Federal Reserve. So far this year, the Fed has raised interest rates four times and plans to continue raising their.

This means that your HELOC payments are likely to increase in the near future in our current economic environment. It is therefore essential to ensure that your income can easily adapt to fluctuations in your monthly payments.

Home equity loans, on the other hand, have fixed interest rates. In an environment of rising interest rates, such as the one we are experiencing today, this can prove beneficial for owners who will not have to worry about their rates increasing - and therefore their payments.

You will make higher monthly payments if your rate increases.

If interest rates stay high or rise, be prepared to continue making higher monthly payments over time with a HELOC. With experts predicting a potential recession On the horizon, it's important to consider your job security and how much emergency savings you have if major life events occur, such as a layoff. Most financial experts recommend keeping at least three to six months of living expenses in an emergency fund if possible.

Make sure you can afford to continue making payments on your first mortgage as well as your equity loan (more commonly known as a second mortgage), should any changes in your financial situation occur.

With a home equity loan, however, you never have to worry about your monthly payments increasing because these loans have a fixed interest rate that doesn't change. Currently, the average interest rate for a $30,000 home equity loan hovers around 7% and HELOCs are at 6.5%, according to Bankrate.

An increase in debt can lower your credit score.

A HELOC is a revolving line of credit that works like a credit cardso maintaining a high balance over time can lower your credit score. Although one of the benefits of a HELOC is that you can only make interest payments during the initial drawdown period, once your repayment period begins your monthly payments will increase as you will also begin to repay the major.

Make sure you can handle such an increase comfortably within your budget. Use Bankrate HELOC Calculator Where home equity loan calculator to determine if your monthly budget can support a second mortgage payment. Making regular, on-time payments for your HELOC can also have a positive impact on your credit score.

Falling home values ​​can limit your loan.

After two years of record home value appreciationhome prices in the United States are, on average, up 42% since the start of the pandemic.It's fine, until one recession or some other cataclysmic economic event causes home values ​​to plummet again, in which case borrowing against your home equity could backfire.

When your outstanding loan balance ends up being more than the value of your home, your lender has the option of freezing or reducing your line of credit since your home can no longer be used to secure the loan. Having a loan balance larger than your home is worth is known as negative equity, or when you're "upside down" on your mortgage.

How to protect yourself from the risks of home equity loans

If interest rates continue to rise, which experts expect, one option is to convert a HELOC to a Fixed Rate HELOC or a home equity loan so you can fix your interest rate and keep your payments consistent.

In general, it is prudent to consult a financial adviser when making important financial decisions such as taking out a loan on your home. Financial professionals can help you determine if such a loan is right for your long-term financial goals.

Either way, it is crucial to model different versions of your budget to make sure you can afford your monthly payments even if your financial situation changes. Determine the maximum loan amount you can cover in the event of an increase in interest rates or a life event like job loss so you can continue to make payments without interruption, regardless of the factors macro and microeconomics.

As always, keep track of your credit and sign up for a free weekly credit report to make sure your credit score stays healthy, because you'll likely have a balance for years with a home equity loan.

The bottom line

Home equity loans and HELOCs carry the risk of losing your home if you miss several payments. In times of economic uncertainty and with the Fed poised to continue raising rates, it's essential to make sure your monthly budget can handle fluctuations in your second mortgage payment if your payments increase. As a homeowner, you need to weigh the pros and cons of securing a loan with your property. And as with any loan, it's always a good idea to shop around with multiple lenders and compare rates and fees to ensure you're getting the most favorable terms available.