What Are The Risks Of A Home Equity Loan?

Home equity loans are loans in which the lender uses your home as collateral to allow you to borrow money. Your mortgage lender may be able to seize your property if you fail to repay your mortgage loan. As a positive, they are easy to qualify for and usually come with low-interest rates.

A home equity loan may seem like a logical choice if you need cash and your home has equity built up. If you are unaware of the risks and responsibilities of borrowing money, a home equity loan can put you in a financial bind. Following are the main risks associated with home equity loans:

What Are The Risks Of A Home Equity Loan?

You are at risk because your home is the collateral for the loan.

If you are unable to pay your mortgage, you may face foreclosure. It is essential to select the loan amount, a term carefully, and an interest rate to allow you to repay the loan during good times and bad comfortably.

Even so, lenders do not usually want to foreclose on your home, even if you secured the loan with your home. The foreclosure process is expensive and does not guarantee that the lender will recover all of their losses, especially if you owe more on your mortgage than the value of your home. Foreclosures can occur in declining markets when properties lose value.

Variations in interest rates

Most banks offer floating interest rates to their customers, despite offering both fixed and floating rates to banks and other financial institutions. You may find it advantageous to opt for a floating interest rate in declining interest rate markets, but it may pinch your pockets during rising interest rates. The scenario is the same if you choose a fixed interest rate.

Don’t spend beyond your means merely because the money is available.

It is quite possible that you borrowed a HELOC with a specific purpose in mind, such as tuition or home repairs, only to have used a substantial portion of it to purchase a toy you did not need. Alternatively, you could use it as your ATM. You could not resist the temptation of readily available money in either case. However, now that tuition is due, the money has been spent. You should only borrow against the equity in your home if you plan to improve your financial situation or your quality of life. These can include home improvements, educational expenses, emergency expenses, and significant life events, such as a wedding. It is never a good idea to use the equity in your home as “mad money”.

Underwater exploration

If you borrow against your home’s equity, and later its value declines, you will be obligated to repay more than the value of your home. Being underwater on your mortgage is also known as being upside down. This occurred during the subprime mortgage crisis of 2008, and standards were changed. However, it is still possible, so be on your guard.

Is a home equity loan the right choice for you?

Due to the pros and cons of taking out a home equity loan, your best option may be to evaluate a few different financing options, calculate your monthly payment, and determine which makes the most sense.

The risk of falling behind on those monthly payments and potentially losing your home may not be so pressing if you have a steady job and borrow a reasonable amount against your home. In that case, a home equity loan could be your most affordable option for accessing the funds you require. Carefully consider your options before signing any documents.

Eligibility for home equity loans

As with a mortgage or auto loan, home equity loans operate similarly. In general, the borrower receives a lump sum of money repaid over a fixed period with a fixed interest rate. Historically, the rates have averaged about 6%, with some loans available at a lower rate with excellent credit scores.

Most of the terms range from five to fifteen years, although some can extend as long as twenty years. The approval is not guaranteed, by the way. After the 2008 housing crisis, banks were much more cautious when they used to rubber-stamp transactions. A lender evaluates your application and ensures that the 80% loan-to-value ratio is not exceeded.

Like most loans, home equity loans will only be approved if you can demonstrate your ability to repay the loan. Being able to repay is a precious asset. Financial institutions verify a borrower’s financial stability by reviewing credit reports. Pay stubs, tax returns, investment statements, etc., must be provided as proof of income. Your credit will also be carefully checked. You will be required to submit an appraisal. The entire process could take several weeks (possibly months) before any funds are released.

It is similar to applying for a mortgage loan. There is another similarity: You should compare rates with banks, credit unions, and online lenders to find the best deal. A lender does not want to take a risk. You must do it as well. Home equity loans are secured loans, which means your home is technically at risk since it is the collateral for the loan. If something drastic occurs, such as losing your job or suffering a severe medical condition, and you cannot make your mortgage payments, your home might be foreclosed.

If you are hesitant to sell your home due to the fluctuation of the real estate market, it may be not easy. Consider other alternatives, such as mortgage modification. Make sure you understand what you are getting into. In some cases, your financial needs can be met via a zero-interest credit card or personal loan, options that do not require you to put your home at risk. To calculate the amount of your new mortgage payment, it would be helpful if you had a detailed list of your income and expenses.

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