Choosing a home equity loan or home equity line of credit (HELOC) is something that should be done with caution, because of the risk involved. Knowing the risks can help you to decide if it’s the best borrowing option for you.
Home Equity Loan and HELOC Risks
While it’s true that any type of loan does come with some risk, a home equity loan can be much different than if you were to default on payments for a personal loan or credit card.
When you use your home equity as collateral for the two types of loans, home equity loans and HELOCS, if you were unable to make your payments you could lose your home.
The terms vary by lender, but HELOCs typically have adjustable rates. This means that if the interest rate were to rise, so do your payments. In Canada, a home equity loan will allow you to borrow up to 80% of the property’s appraised value, after you have subtracted anything that you have left to pay on your mortgage.
If you had a home worth $600,000, you could borrow up to $480,000. But after calculating the mortgage debt still left to pay, it will be less. Let’s suppose you still had $400,000 of your mortgage to pay. You would be able to borrow up to 80% of the equity that you have in the home ($200,000 in equity) which would be $160,000 available to borrow.
With a HELOC, borrowing up to 65% of the property’s appraisal value is possible. In cases where a lender would combine your HELOC with the remainder of your mortgage, it is possible to borrow up to 80% of the appraisal value. If you have gone this route, you are able to borrow against the line of credit when you like once the LOC (line of credit) is secured.
With a Home Equity loan it will be like having two mortgages at the same time, and a HELOC is a line of credit requiring you to keep up the minimum monthly payments.
Risks When Your Home is on the Line
Since increases in interest rates are unpredictable, and a HELOC has a variable rate, it’s possible that you might pay more for the loan than anticipated. Sometimes making those minimum payments for a HELOC can become unmanageable down the line.
There is also the possibility that since the value of your home can rise or fall with the fluctuation of the real estate market, a home equity loan could be based on a previous value and it could mean you would lose money if you were to put it up for sale.
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When It Can Be Worth the Risk
What you plan to use a home equity loan or HELOC is also an important consideration. A smart move is when you are using the money for home renovations or home improvement, as this would be putting money into your investment which can increase the value. Depending on the project, sometimes the entire amount can provide returns. When you put money into a kitchen or bathroom renovation as much as 80% or more of the cost can be attributed to the new value, making these remodels the ones that pay off the most. Replacing roofs or windows also rank high, with most other home projects the returns tend to be less.
Advantages of Using Your Home Equity
If you make use of your home’s equity to strengthen its value by using the money for renovations, your home should be worth more. If you choose to use the funds for other options, you can do things like paying down debt, going on vacation or paying for your child’s education, although we still stand by the idea that any equity should be used to invest in the home itself.
Disadvantages of Using Your Home Equity
The fees involved before you are able to borrow will add up. If choosing a variable rate, things can change and the cost of borrowing can go up considerably. Then there is the possibility that you are unable to make payments on a home equity loan and risk being foreclosed on. It’s imperative that you are certain you will be able to manage the payments.
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Avoiding the Risks of HELOC or Home Equity Loans
If the reason for borrowing is a big purchase, travel, buying a car, paying off credit card debt or something not related to investing the equity of your home back into your home, you are usually better off using a credit card or getting a personal loan instead.
Like any loan, it needs to be repaid, and failing to do so with a HELOC or Home Equity Loans can put your home at risk of being taken by the lender if you default on payments.
Before choosing a HELOC or Home Equity Loan, be certain it’s for the right reasons and that you are certain you would be able to make payments should your income situation change.