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The Downside of Home Equity Loans

The Downside of Home Equity Loans
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It seems so simple and they’re so easy to get. But there’s a catch especially if interest rates keep going up.

A home-equity loan or line of credit designed to use the value of your home as a source of collateral.  How much you can access depends on how much equity you have in your home, your credit rating and your income.  Monthly payments can be as low as the interest on the loan or you can pay the minimum interest payment plus part of the principle.  And that’s where things start to get a bit tricky for many people with a home-equity line of credit.

Home-equity loans and the Prime Rate

Minimum monthly interest payments have to be paid, but failure to payoff any principle can get you into a debt spiral.  Significantly, the interest rates can also go up.  Most home-equity loans are tied to the prime rate with an agreement that the interest due will be a certain percentage above prime.  Over the past few years the prime rate has been at an all time low, but there are indications the Fed is going to begin raising the rate.

The recent Brexit decision in the U.K. may delay a rate hike, but it seems that a hike is inevitable in 2017.

Easy come, easy go 

Another challenge for many people with a home-equity line of credit is that it’s too easy to spend the money.  The rationale is often that the interest rate on many home-equity loans is less than the interest rate on credit cards or car loans.

The logic leads to money from the home-equity line of credit being used to purchase items that continue to bloat the size of the principle from the home-equity loan, raise the monthly interest rates and reduce the ability to pay down the principle.  If you genuinely need a new car it might make sense to use the home-equity loan funds, but too often other purchases that aren’t necessary are incurred.

The interest versus principle facts

Many Home-equity lines of credit limit how long you can pay interest only as a minimum monthly payment.  This could mean that you have a 10-year grace period of interest only payments, but after the 10 years principle payments will be added to the minimum monthly payment.

You should also be aware that some home-equity loans shift the interest rate after 10 years from an equation tied to the prime rate to a fixed interest rate plus principle for the next 15 years.   This could double the minimum monthly payment and make it increasingly difficult to avoid default.

Beware the Draw Period 

The draw period is a set period of time that you can borrow from the home-equity line of credit.  When the period expires you can reapply for a home-equity line of credit but you may be denied if your financial situation has changed.  In that case, the total amount of the loan comes due.  Some people have been forced to sell their homes quickly to satisfy this demand.  It’s another reason why the principle payments should be taken seriously and taken into consideration when spending any amount of money from the loan.

The Risk of Default

If you are denied after the draw period and can’t sell your home you may be forced by the court into foreclosure and need to find somewhere else to live.  Unemployment and the inability to make minimum monthly interest payments can also set you on the road to default.

The rise and fall of real-estate value 

If someone borrows 100% of their homes value and the property value falls, the can be in a situation where even the sale of their home won’t satisfy the total loan amount.

The discipline of a home-equity line of credit 

If you’re considering a home-equity line of credit do a gut-check on your spending habits and sources of income.  It makes sense for some people to pay off credit-card debts, student loans or car loans if the interest rate on a home-equity loan is lower, but the same payments applied to the other loans should continue to go towards paying down the principle on the equity-loan.  The temptation is to simply make the minimum interest payments and that’s where this type of loan and lending can get you into trouble.


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