What Are the Risks Associated with Getting a Home Equity Loan?

 A home equity loan allows homeowners who have considerable equity in their houses to obtain much-needed cash at a cheaper interest rate than other types of unsecured debt such as credit cards and personal loans. House equity loans are less expensive since they use the equity in your home as security.

There are various dangers associated with taking out a home equity loan, but the largest one is that you won't be able to pay it back and end up losing your house to foreclosure.

What Are the Risks Associated with Getting a Home Equity Loan?
What Are the Risks Associated with Getting a Home Equity Loan?

Property equity loans enable homeowners to use the value of their homes to obtain cash fast and cheaply. Borrowing against your home's equity may be worthwhile if you're certain you'll be able to make timely payments, and especially if you utilize the loan for upgrades that boost the value of your property. However, if you fall behind on payments, you face a number of problems. Before taking out a home equity loan, consider these dangers as well as the lender's conditions.


Obtaining a Home Equity Loan for the Wrong Purposes

Regarding home equity loans, we spoke with various financial advisers. Their repeated response was that they only urge consumers to take out a home equity loan for things that would increase the value of their property. There is no other option since the hazards of taking out a home equity loan are simply too great.

The creator of LifeManaged and certified financial advisor (CFP), Thanasi Panagiotakopoulos, expressly cautions against using a home equity loan to pay for education. Marguerita Cheng, CFP and owner of Blue Ocean Global Wealth, concurs but adds that there are alternative choices, such as student loans, that do not put your house in danger.

According to Kimberly Foss, a CFP and the founder of Empyrion Wealth Management, "home equity should never be utilized for speculative purposes, including the purchase of the real estate, since if the market turns against you, you might lose the value you've built up in your house." You could still end yourself in debt even if you exercise caution and only take out a home equity loan for the proper reasons.


Increasing Debt

There is no limit to the number of home equity loans you may take out, similar to a home equity line of credit (HELOC), as long as you continue to have the required income and credit score and your house's equity grows. The risk of spiraling further and deeper into debt with home equity loans, on the other hand, cannot be overstated.

A home equity loan may be approved with a combined loan-to-value (CLTV) ratio as high as 90%, however many lenders want a CLTV ratio of 85% or less. The CLTV is calculated by dividing the total sum of all your loans by the current assessed value of your property.

  • A home equity loan of up to $40,000 may be granted for a person with a property worth $100,000 and a current mortgage balance of $50,000. That example, a CLTV of 90% equals $50,000 initial mortgage debt + $40,000 home equity loan balance.

In keeping with the previous illustration, the borrower may continue to occasionally take out home equity loans if the value of their property rises. 

Unless the money from the home equity loan is utilized to make modifications to the home that enhance the value above the mortgage, they have fallen farther into debt over time rather than enhancing their wealth via their increased home equity.


Mortgage That Is Submerged or Inverted

What happens if your house's value drops dramatically is a major danger of taking out a home equity loan. If your loan balances exceed the value of your house, you may find yourself upside down or underwater on your mortgage. 

When this occurs, you may find yourself unable to sell your property or relocate without losing money and damaging your credit. During the 2007-2008 financial crisis, millions of homeowners were in this horrible scenario.


Frequently Asked Questions About the Risks of Taking a Home Loan

A Home Equity Loan Vs. a Home Equity Line of Credit (HELOC): Which Is Safer?

Home equity loans and house equity lines of credit (HELOCs) both use the equity in your home as collateral and entail the same risk of losing your home to foreclosure if you fail to repay them. Their interest rates are where they diverge. The interest rate on a home equity loan is fixed, but the interest rate on a HELOC is frequently variable.

As a result, if your HELOC has a big sum, a home equity loan may be safer than a HELOC. With a HELOC, there's also the chance that interest rates will climb to the point where you can't afford your monthly payment. Your interest rate and payment stay constant with a home equity loan.


What Are Home Equity Loan Alternatives?

According to Chloé A. Moore, a certified financial planner (CFP) with Financial Staples, the greatest option for a home equity loan is a fully loaded emergency fund. If you don't already have emergency reserves, you may be able to adapt your budget and postpone the home equity loan. 

If you're in a jam and can't wait, a personal loan is a choice with lower interest rates than a credit card but without putting your property in danger.


Are There any Fees Associated with Home Equity Loans?

Many home equity loans do not include expenses such as closing costs. Before you sign up for anything, shop around for a lender (or seek a mortgage broker's help) and evaluate each lender's costs, rates, and processing timeframes.


If you default on a home equity loan, may your house be foreclosed?

True. An additional mortgage on your property is a home equity loan. Your house might be foreclosed upon if you are unable to make the payments on your home equity loan.

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