Taking out a home equity loan is a way for those with significant equity built up in their homes to access much-needed cash at a lower interest rate than other forms of unsecured debt like credit cards and personal loans. Home equity loans are cheaper because they use the equity that you have in your home as collateral. While there are many risks to taking out a home equity loan, the biggest risk is losing your home to foreclosure if you can’t afford to pay your home equity loan back.
- Home equity loans use your home as collateral. If you can’t keep up with payments, you could lose your home.
- Home equity loans should only be used to add to your home’s value.
- If you’ve tapped too much equity and your home’s value plummets, you could go underwater and be unable to move or sell your home.
Taking Out a Home Equity Loan for the Wrong Reasons
We interviewed several financial advisors about home equity loans. Their consistent response was that they only encourage clients to take out a home equity loan for something that will add to their home’s value. The risks of taking out a home equity loan are just too high for anything else.
Thanasi Panagiotakopoulos, a certified financial planner (CFP) and founder of LifeManaged, specifically advises against taking out a home equity loan to pay for college. Marguerita Cheng, a CFP and owner of Blue Ocean Global Wealth, agrees and adds that there are better options, such as student loans, that don’t risk your home.
“Home equity should never be accessed for speculative purposes, including the purchase of real estate, because if the market goes against you, you could lose the value you’ve built up in your home,” warns Kimberly Foss, a CFP and founder of Empyrion Wealth Management.
Even if you are careful and only take out a home equity loan for all the right reasons, you can still find yourself in a financial bind.
Similar to a home equity line of credit (HELOC), there is no limit to the number of home equity loans that you can take out—as long as you continue to have the income and credit score to qualify and your home’s equity increases. However, the risk of spiraling further and further into debt with home equity loans cannot be understated.
Many lenders require a combined loan-to-value (CLTV) ratio of 85% or less, but some lenders will approve a home equity loan with a CLTV as high as 90%. The CLTV takes the total balance of all your loans divided by the current appraised value of your home.
For example: A person with a home valued at $100,000 and a current mortgage balance of $50,000 could be approved for a home equity loan amount up to $40,000. That is, $50,000 first mortgage balance + $40,000 home equity loan balance ÷ $100,000 = a CLTV of 90%.
To continue that example, if that person’s home value continues to increase, they can continue to take out home equity loans periodically. Over time, instead of increasing their wealth through their increased home equity, they have spiraled further into debt—unless the home equity loan funds are used to make improvements to the home that increase the value above the amount of the debt.
A big risk to taking out a home equity loan is what happens if your home value decreases significantly. If the balances of your loan are higher than your home’s value, you could end up upside down or underwater on your mortgage. When this happens, you may find yourself unable to sell your home or move without losing money and tanking your credit in the process. This unfortunate situation happened to millions of homeowners during the 2007–2008 financial crisis.
Can Your Home Be Foreclosed on If You Don’t Pay Off a Home Equity Loan?
Yes. A home equity loan is a second mortgage on your home. If you can’t afford to make payments on your home equity loan, then your home could go into foreclosure and you could lose your home.
Do Home Equity Loans Have Fees?
What Are Alternatives to a Home Equity Loan?
The best alternative to a home equity loan is a fully funded emergency fund, according to Chloé A. Moore, a certified financial planner (CFP) at Financial Staples. If you don’t already have emergency savings, you may be able to adjust your budget and postpone whatever you need the home equity loan for. If you find yourself in a bind and can’t delay, then a personal loan is an option with cheaper interest rates than a credit card but doesn’t risk your home in the process.
Is a Home Equity Loan Safer Than a Home Equity Line of Credit (HELOC)?
Home equity loans and home equity lines of credit (HELOCs) both use your home’s equity as collateral and carry the same risk of losing your home to foreclosure if you can’t pay them back. Where they differ is in their interest rates. A home equity loan has a fixed interest rate, while a HELOC usually has a variable interest rate. Because of this, a home equity loan can be safer than a HELOC if your HELOC has a high balance. With a HELOC, there’s an additional risk that rates could rise to the point that you can’t afford your monthly payment. With a home equity loan, your rate and payment remain fixed.
The Bottom Line
Home equity loans are best used solely for projects that will lead to an increase in your home’s value. If you use them frivolously, then you erode your equity in your most valuable asset. Be cautious when tapping into your home’s equity and remember that you could lose your home if you can’t keep up with payments, or you could end up unable to move if you’ve tapped that equity too much and your home’s value decreases.