Home equity loans allow you to use a part of your equity as collateral for a new loan. Home equity loans are typically revolving credit lines, although they are considered installment loans. This means you will have a credit card or credit line issued with limits based on the equity you have in your home. Each month, you can choose to spend a given amount of the credit or pay down a given amount of the balance. Despite being a flexible form of financing, there are a number of pitfalls with home equity loans.
#1 Home Equity Loans Raise your Debt to Asset Ratio
You want your ratio of debt to assets to be as low as possible. This number states how much you owe to lenders compared to how much you own in personal assets. When you begin paying off a mortgage, you are converting debt to asset. This means you are doubly-improving your debt to asset ratio with each payment. However, when you collateralize a portion of your asset, then you are additionally doubly-hurting your score.
#2 Home Equity Loans may lead to Foreclosure
The mortgage on your home is a senior debt, meaning the mortgage company owns the title to your home. Your home equity line is subordinate, and the home equity lender does not have a title to the property. However, if you default on your home equity line, the home equity lender may decide to purchase your primary mortgage from your mortgage lender. Then, the subordinate lender becomes a senior lender. The lender may force your home into foreclosure and seize the asset.
#3 Home Equity Loans Have High Interest Rates
Most home equity lines have high interest rates because they are subordinate loans. Loans that are secured with collateral typically have lower interest rates. In this case, even though you are using your home equity to get the credit, you are not actually placing your home as collateral. This means you are potentially risking your home without capitalizing on the lower interest rate that would typically come with a secured loan.
#4 Home Equity Loans Have Adjustable Interest Rates
It is uncommon to receive a fixed-rate loan based on your home equity. The most common way this would occur would be if you are seeking an installment loan, not a revolving line, in order to make home repairs or improvements. If you are taking out a revolving line, though, be prepared for adjustable rates. Adjustable rates may increase your cost in financing over time and make it more difficult for you to control the cost of the loan.
#5 Home Equity Loans Compromise Financial Stability
For all of the factors above, home equity loans greatly compromise your financial stability. For most people, a home is the single greatest asset on a balance sheet. Home ownership is the route to greater financial freedom in the future. It is also the route to a secure retirement. When you place your home on the line as collateral, you are risking the asset that provides you the most security in the long run.