Tapping into your home’s equity by taking out a home equity loan or line of credit may seem like an easy way to get fast cash, but there are considerable risks that you need to think about. Borrowing money against the value of your home might provide short-term financial relief, but it can jeopardise your long-term financial security if not done very carefully.
Gaining a full understanding of the potential downsides of leveraging your home’s equity can empower you to make a prudent financial decision. After learning about the hazards involved, you may determine there are wiser ways to access funds than putting your most valuable asset at risk.
First, let’s review briefly what equity actually means so you understand this critical concept before considering borrowing against it. The home’s equity represents your property’s current market value minus any amount you still owe on your mortgage loan.
For example, if your house appraises for $300,000 in the current real estate market and you have an outstanding mortgage balance of $180,000 left to pay off, then you would have $120,000 in equity in your home. Using a detailed check stub and your loan-to-value ratio, the lender can calculate the maximum you can borrow.
By examining factors like your income and credit scores and verifying home value with an appraisal, the lender calculates the maximum loan amount you qualify for based on your existing equity. So while tapping into home equity does provide a particular way to access a lump sum of cash, the risks outweigh the benefits of doing so in many situations.
Here are seven key reasons why homeowners should be very cautious before using equity in their homes.
One of the scariest dangers of home equity loans or lines of credit is that they use your house as collateral for the debt. This means if you, for any reason, fail to repay the equity loan as required by the terms, the lender has the legal right to foreclose on your home.
Even if you have built up substantial equity over years of mortgage payments, defaulting on the equity loan could still result in you losing your most valuable financial asset – your home. This is an incredibly risky proposition. While the lender will not take foreclosure action lightly given the costs involved, missed payments or lack of cash to pay off the loan in full could leave you homeless. Tapping equity may provide money today, but it leverages the long-term stability of your shelter.
By borrowing against your home’s equity, you reduce the gap between the current market value of your house and the amount you still owe on it through mortgage and equity loan debts. This significantly shrinks the protective equity cushion that you have built up through years of on-time mortgage payments and rising property values.
It limits your insulation against a housing market downturn. For instance, if real estate prices decline and you’ve already borrowed heavily against your home equity, you could end up owing financial institutions more than your house is actually worth. This scary scenario is called being “underwater” or “upside down” on your mortgage, and it can be disastrous. If you needed to sell, you’d have to bring cash too close to pay off lenders.
And it can leave you trapped in a house you can’t afford. So tapping equity now can erase the equity safety net you may desperately need later if market conditions change.
Like taking out a new mortgage, opening a home equity line of credit or loan incurs upfront closing costs and fees that can range from 1% to 5% of the total loan amount. These charges include appraisal fees to verify home value, application and processing fees, and loan origination charges.
There may also be title insurance costs and other government filing fees depending on local regulations. These thousands of dollars in upfront equity loan costs get deducted from the total maximum loan amount you can receive. So if you borrow $100,000 against your equity, you may only actually get $95,000 in your pocket after closing expenses. These fees counteract part of the financial benefit of tapping your equity.
A valuable perk of your primary mortgage is that the IRS allows you to deduct the interest paid on up to $750,000 of home loan debt to lower your taxable income. This mortgage interest deduction can represent huge savings each year.
However, the same tax deduction does NOT apply to interest paid on home equity loans or lines of credit. This interest remains fully taxable and drives up the true long-term cost of borrowing against your equity. Without the write-off, your annual interest obligation on a $50,000 equity loan could be $500 to $1,000 higher.
Certain types of home equity loans include a balloon payment provision that requires you to pay off a large chunk of the principal loan balance after a specified period of time. Failing to fully pay this lump sum balloon payment as required can put you in default and at risk of surrendering your home to foreclosure.
Facing an unexpected balloon repayment on your equity loan when your finances are already tight creates massive stress. Even if you obtained the funds for valid reasons, lacking the cash flow to cover a big balloon repayment in 5-7 years could force you out of your home in the long run.
Home equity lines of credit typically have variable interest rates tied to market indexes like the Prime Rate that change over time as economic conditions evolve. This means your required minimum monthly payments and total interest expenses will rise if rates increase across the economy.
Some fixed-rate home equity loan products also include rate adjustments or allow the lender to reset to higher rates after an initial period. This unpredictability of borrowing costs makes reliable budgeting very difficult when you tap equity. You want to avoid ending up in a poor house because equity debt payments increased after you borrowed the money.
The “easy money” psychology sometimes connected with equity borrowing leads many homeowners to overspend or make impulsive purchases with the loaned funds that actually make their financial situation worse. It’s wise to leverage equity to pay for a child’s college education, make essential home repairs and renovations, or consolidate high-interest credit card debts.
But spending borrowed equity to finance expensive vacations, shopping sprees, cars, or boats you can’t afford is not prudent. Instant gratification often leads to bigger debt burdens and financial headaches down the road.
If you need cash to cover major expenses or debt payments, there are typically safer alternatives than burdening your home further with additional equity debt:
- Refinance your existing mortgage at a lower interest rate to reduce your monthly payments and free up extra money in your budget. You tap equity slowly over time through savings versus a risky lump sum loan.
- Obtain a small fixed-rate personal loan from your bank or credit union to consolidate other debts at a reasonable rate.
- Use 0% intro rate credit cards responsibly for temporary financing needs and then commit to paying off the full balance promptly before interest accrues.
- Sell valuable assets, electronics, jewellery, or unused equipment you already own through local marketplaces or online apps to generate cash without taking on debt.
- Rent out an extra room, converted garage space, or little cottage/ADU on your property to earn rental income from tenants. Make better use of your existing home.
This handy table summarises the key pros and cons of leveraging home equity through loans or lines of credit:
|Potential Benefits||Serious Risks to Consider|
Deciding whether or not to tap into your home’s hard-earned equity is a major financial decision that requires careful thought and analysis. While borrowing against your equity can provide access to cash for pressing needs, the risks of losing your home, eroding your equity, and incurring additional debt should not be taken lightly. Thoroughly research all your options and weigh the short-term benefits versus long-term consequences before moving forward.
If you proceed with caution and restraint, a modest equity loan may be feasible. But for most homeowners, the potential downsides outlined above outweigh the upsides. Your home is likely your most valuable asset – don’t jeopardise it without fully understanding the hazards involved. With prudent planning and budgeting, more secure alternatives almost always exist.
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