4 home equity borrowing risks to know (and how to protect against them)

The economic climate has been challenging for many Americans. Inflation and the elevated costs of goods, services, and labor have been troublesome and some have found themselves in need of extra help financially. 

While credit cards are an option, those come with double-digit interest rates right now. For homeowners, a home equity loan or home equity line of credit (HELOC) may be a better option. With lower rates and the ability to large sums of financing, these options can often help consumers pay off debt, cover home repairs, or just pay for unexpected expenses or medical bills.

But this type of borrowing isn't perfect. In fact, there are some major risks to consider, too. We asked some experts about the potential risks, along with the ways to protect against them.

Are you considering a home equity loan now? See what rate and terms you can qualify for here.

4 home equity borrowing risks to know (and how to protect against them)

Ready to access your home equity? Before you proceed, be sure to thoroughly understand these four potential risks:

Your home serves as collateral

With a home equity loan or HELOC, your home is the collateral. That means if you skip payments, the lender has the right to claim your home and sell it to cover those missing payments. 

"If a person defaults on a credit card, that doesn't have any ramifications for their home," says Shmuel Shayowitz, president of Approved Funding, a mortgage lender in Bergen County, N.J. "A HELOC default can jeopardize a person's residence."

The potential losses are big with these types of loans — and it could mean giving up your home if you're not careful. To protect against this risk, make sure you have plenty of cash in the bank, and get a clear estimate of what your payments will look like. 

"The best approach is careful budgeting and analysis," says Matt Dunbar, senior vice president of the Southeast Region at Churchill Mortgage. "Break down your monthly budget to consider the payment and any future variability in payments due to interest rate changes. Budgeting conservatively is also key."

Start calculating your potential home equity loan costs online now.

You could end up upside down on your mortgage

Home equity loans can also put you at risk of going upside down on your loan if your home loses value. This means you'd owe more on the loans against the house than the home is actually worth — a problem, because if you need to sell the house, your sale won't net you enough cash to cover those loan balances.

That's why it's crucial you "leave enough equity to withstand any market shifts," Dunbar says. 

"Real estate values have risen dramatically in recent years, but it's important to consider that this surge was largely driven by high demand fueled by historically low interest rates and inventory that did not adequately satiate demand," Dunbar says. "Values may decrease at some point."

Before you borrow against your equity, then, research property value trends in your area and look at sales of homes comparable to yours. If you spot recent jumps in value that don't make sense or you see prices moving downward, "set a limit on how much equity you're willing to leverage," Dunbar says. This will offer a buffer in case your home loses value in the future.

You will reduce what you can leave to beneficiaries

Using your equity now also stops you from using it later on. That might mean you'll have less to pass on to your children or heirs once you pass away, or it could eat into your retirement opportunities, too.

As Jennifer Beeston, branch manager and senior vice president of mortgage lending at Guaranteed Rate, explains, "I have seen way too many people over the years treat their home like a piggy bank and then when retirement comes, they can't afford their home."

Make sure you have your future goals in mind before you borrow from your home equity. Know what you plan to leave to heirs and how much you need from your home for retirement. If there's no equity left to borrow from, you may want to consider other financial solutions.

You might face more financial stress

Home equity loans can also contribute to financial stress, as they add an additional monthly payment. With HELOCs, you'll typically have a variable interest rate, so your payment may not be easy to estimate or plan for either. Again, good budgeting is critical.  

"For households with multiple incomes," Dunbar says, "relying on the most consistent and conservative income for budgeting is a safer approach than counting on multiple, seasonal, commission, or bonus incomes."

Make sure you only borrow what you need, too. If you're borrowing cash to cover a home renovation, for instance, you'll want to have a contractor provide an estimate you can base your loan amount off of. 

"I would not advise taking equity out for a home project until you had the property fully bid out — meaning you know exactly what it will cost," Beeston says. 

Home equity alternatives to explore

Home equity loans and HELOCs aren't your only option if you need cash as a homeowner. You could also sell your home and move to renting (or a smaller property), and leverage the sale proceeds however you wish.

A cash-out refinance is an option, too, though this would require replacing your existing mortgage loan with a new one — including a new rate, term and payment. This might not be wise if you've locked in one of the record low rates offered during the pandemic. 

As Beeston puts it, "If you have an interest rate below 5.5% I would encourage you to do everything you can to keep it."