6 risks to consider before tapping into your home's equity
With interest rates high and economic uncertainty looming, many homeowners are eyeing their home equity as a potential source of borrowing. After years of rapidly rising home values, the average homeowner with a mortgage now has about $300,000 in home equity, with about $190,000 potentially tappable. At the same time, home equity loan rates remain relatively low compared to many other borrowing options.
Accessing your home equity with a home equity loan or a home equity line of credit (HELOC) can provide much-needed funds for things like home renovations, debt consolidation, college tuition bills or shoring up retirement savings. However, while tapping your home's equity may seem appealing right now, it also comes with significant risks that should give any type of borrower pause before proceeding.
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6 risks to consider before tapping into your home's equity
Here are some of the key risks to carefully consider before you access the money from your home's equity:
Risk of foreclosure
The biggest risk of a home equity loan or HELOC is that you are putting your home up as collateral in return. If you fail to make the payments on the money you borrow, the lender can foreclose on your property.
If you borrow money with an unsecured loan, like a personal loan, missing payments will hurt your credit but it won't put your home ownership at risk. With home equity debt, that risk is front and center. And, given that your home is likely your most valuable asset (or one of your most valuable assets), that's not something to take lightly.
Risk of running up too much debt
Another major risk of tapping your home's equity is that it enables you to rack up a lot of debt very easily. While using a home equity loan or HELOC for targeted needs, like paying for college or consolidating high interest debt, can make sense, it's easy to fall into a trap of treating it like a piggy bank to fund a lifestyle you can't really afford long-term.
Learn more about the top home equity loan rates you could get today.
Risk of going underwater on your home
Taking out a loan against your home's equity also increases the risk that if housing prices fall, you could end up underwater and owing more on your mortgage and home equity loans than your home is worth. This makes it impossible to get out of the mortgage without writing a big check to the lender and could make it difficult to sell your home or refinance your mortgage in the future.
Risk of reducing your home equity
Every dollar you borrow against your home's equity is a dollar you no longer have access to if you need it down the road. If housing prices rise over time, you'll miss out on borrowing from the increased equity — at least until your loan is fully repaid.
Risk of paying too much in interest
While home equity loan rates are fixed, HELOC rates are typically variable, meaning they can change over time based on the overall rate environment. While HELOCs often have relatively low introductory interest rates, but if rates rise over time, this type of borrowing may end up becoming quite expensive.
There's also the risk that rising interest rates may make it harder to afford the payments on your combined mortgage and home equity debt. That said, you do have the option to refinance your home equity loan or HELOC if rates fall over time.
Risk of missing out on tax deductions
Generally, you can only deduct the interest on a home equity loan or HELOC if the funds were used for a specific purpose, like repairing or substantially improving your home. Miss that criteria and the interest you pay on the money you borrow likely won't be tax deductible.
Managing the risks of home equity borrowing
While the risks of tapping your home's equity are significant, they can often be managed prudently if you are financially disciplined. For example, it's critical to have a realistic, concrete plan for paying back any home equity debt in a reasonable timeframe. And, running the numbers carefully to ensure you can truly afford the payments, even if interest rates rise substantially, is an absolute must.
You'll also want to maintain a robust emergency fund with six to 12 months' worth of expenses that is separate from your home equity funds. This ensures you have a buffer to continue making payments if you lose your job or face other financial hardship. Having a backup plan like temporarily cutting expenses, generating income from a side gig or dipping into investments can also help hedge against missed payments.
Taking a conservative view of potential home price appreciation in your local area may also be wise before betting too much on rapidly rising equity to offset your debt over time. It's best to make plans assuming your home's value will rise modestly, if at all, over the next five to 10 years.
Limiting your combined mortgage and home equity debt to no more than 80% of your home's value can also help provide a cushion if housing prices do decline. This protects you from going underwater on your mortgage and being unable to move.
The bottom line
By being fully aware of the risks upfront and putting guardrails in place, accessing your home's equity can potentially be a viable financial tool when used judiciously. But borrowers should have a healthy respect for the dangers — including potentially losing their home to foreclosure — before moving forward.
