Here's Why a Home Equity Loan Is More Dangerous Than You Think

If you're a homeowner and you need money, whether to renovate your home, buy furniture, take a trip, or pay for education, you may be inclined to tap the equity you have in your home. Equity is defined as the difference between your home's market value and your mortgage balance. If your home's value is $400,000 and you owe $250,000 on your mortgage loan, you're left with $150,000 of equity.

Usually, when you're applying for a home equity loan or home equity line of credit (HELOC), you can pretty easily qualify provided you'll be left with 20% equity in your home. So in the example above, say you want to take out a $50,000 home equity loan. Since that would leave you with $100,000 of equity on a $400,000 property, you're at the 25% mark. So as long as you have decent credit, qualifying for a $50,000 home equity loan might be fairly simple.

U.S. homeowners today are sitting on a collective $30 trillion in home equity. So a lot of people might seek to tap that equity in the coming months.

But just because it might be easy to get approved for a home equity loan doesn't mean it's a good idea. And if you're going to go this route, it's important to understand the risk involved.

Not paying could have serious consequences

Any time you fail to repay a loan, whether it's a car loan, personal loan, or home equity loan, your credit score can take a dive. That's because your payment history carries more weight (35%) than any other factor when calculating your credit score.

As such, when you sign a home equity loan, you run the risk of falling behind and seeing your credit score take a hit. But more than that, if you're unable to make payments on your home equity loan, you could actually risk losing your home.

Home equity loans are secured loans, so they're tied to a specific asset -- your home. In an extreme situation, your lender could force the sale of your home to get repaid should you find yourself unable to repay your loan.

That's why it's important to borrow carefully when you're taking out a home equity loan. Examine your monthly bills and figure out how much they total. Then, see what your paycheck gives you. If, without a home equity loan payment, you're already spending $3,700 a month and you only bring home $4,000, it means you'd really better make sure your monthly home equity loan payments don't exceed $300.

And even that, frankly, is cutting it close. In this situation, you'd be better off limiting those loan payments to more like $200.

Don't be so quick to tap your home equity

If the value of your home is up, you may be eager to capitalize on that by borrowing against the equity you have. But before you do, think about whether you really need to be signing a home equity loan right now.

Home values may be up, but so are borrowing rates in the wake of the Federal Reserve's recent series of interest rate hikes. A home equity loan might cost you more than expected when you factor interest rates into the mix.

If your need to borrow money is pressing, then you may find that a home equity loan is your most affordable option. Otherwise, waiting until interest rates come down could really work to your advantage.