Should You Be Scared to Take Out a Home Equity Loan?

This borrowing option is really a mixed bag.

One major benefit of buying a home is getting to build equity. Equity is calculated by taking the value of your home and subtracting the balance you owe on your mortgage. If your home could sell today for $400,000, and you owe $250,000 on your mortgage, it leaves you with $150,000 in equity.

As of late 2022, the average U.S. homeowner had about $300,000 of equity, according to CoreLogic. And that's equity they can borrow against.

Now, you may be wondering if you should take out a home equity loan to do something like renovate your property. And you should know that while there are benefits to going this route, there's a serious downside to consider, too.

The danger of borrowing against your home

A home equity loan can be an affordable way to borrow, and a relatively easy one. The reason? Your home is used as collateral on the loan you take out.

Let's say you have $150,000 in home equity and you borrow $50,000. Your lender will know that in a worst-case scenario, it can force the sale of your home to get repaid, whereas with something like a personal loan, there's no collateral to fall back on. Because of this, you might snag a more competitive interest rate on a home equity loan.

But there's an obvious danger in taking out a home equity loan: If you fall behind on your payments, you risk losing your home.

This isn't to say that you'll get foreclosed on for missing a single payment, or even a couple of payments. But you should be aware that in a more extreme situation where you're not able to make payments for a long period of time, that risk exists. And that's why you must proceed with caution when taking out a home equity loan.

Is a personal loan a better bet?

A personal loan may be less dangerous, so to speak, than a home equity loan, because your home isn't being used as collateral. But to qualify for a personal loan, or at least an affordable one, you need to have a pretty good credit score. If your credit is poor, you may find that you're charged a lot of interest to take out a personal loan, making that option cost-prohibitive.

Also, any time you fall behind on any sort of loan, whether it's a personal loan, home equity loan, or something else, that delinquency is reported to the credit bureaus, and it can damage your credit score in a very big way. That's why it's important to make sure you can afford your loan payments, no matter which type of loan you're taking out.

If you crunch the numbers and find that you can work your home equity loan payments easily into your budget, then there's less of a danger in taking one out. It's when you sign up for loan payments you can't really swing that you're more likely to run into trouble.