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7 home equity borrowing mistakes new homeowners should avoid now
American homeowners are sitting on a goldmine of equity right now, with the average homeowner having access to approximately $320,000 in home equity currently. This substantial cushion of wealth has many new homeowners considering tapping into their property’s value through home equity loans or home equity lines of credit (HELOCs), particularly as they face major expenses or discover new investment opportunities.
While current home equity borrowing rates — which average 8.41% for home equity loans and 8.52% for HELOCs right now — may seem high compared to the rock-bottom rates of recent years, they still represent a relatively affordable borrowing option — especially compared to other types of lending. With credit card rates exceeding 23% on average and personal loan rates averaging 12.29% currently, home equity borrowing remains an attractive financing solution for many types of homeowners — including those who bought their houses more recently.
However, the decision to borrow against one’s home equity shouldn’t be made lightly, especially in today’s unusual housing market. For new homeowners in particular, several common mistakes could turn this wealth-building tool into a financial burden, and understanding these pitfalls is crucial before tapping into what is likely your largest store of wealth.
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7 home equity borrowing mistakes new homeowners should avoid now
If you’re a new homeowner who’s considering a home equity loan or HELOC, it’s important to avoid these common but costly mistakes:
Borrowing without a clear purpose
One of the most dangerous mistakes new homeowners can make is treating their home equity like a piggy bank for discretionary spending. While home equity can be a powerful financial tool, it should be used strategically for purposes that either increase your home’s value (like home renovations), generate returns (like starting a small business) or consolidate higher-rate debt. Using home equity for vacations, luxury purchases or daily expenses can put your home at risk while providing no long-term financial benefit.
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Failing to consider the total cost of borrowing
Many homeowners focus solely on the interest rate they’re getting on their home equity loan or HELOC without factoring in all the costs associated with home equity borrowing. Aside from the interest rate, borrowers need to consider closing costs, which can range from 2% to 5% of the loan amount, any annual fees tied to their HELOC options and the potential prepayment penalties that can come with this type of borrowing.
Overestimating future home values
The housing market’s strong performance in recent years has led some homeowners to make overly optimistic assumptions about continued price appreciation. While there’s a chance that home equity levels will continue to rise over time, borrowing against your equity with the expectation that rising home values will quickly rebuild your equity cushion is risky. Housing markets are cyclical, and local conditions can significantly impact your home’s value. In turn, it’s important to maintain a conservative equity buffer rather than borrowing the maximum amount available.
Ignoring the impact on monthly cash flow
Taking on home equity debt means adding another monthly payment to your budget. New homeowners sometimes underestimate how this additional obligation will affect their monthly cash flow, especially when they’re still adjusting to the costs of homeownership. So, before borrowing, create a detailed budget that accounts for your existing mortgage payment, property taxes, insurance, maintenance costs and the new home equity payment.
Choosing the wrong type of home equity product
Not all home equity products are created equal, and selecting the wrong one can be costly. Home equity loans provide a fixed rate and predictable payments but require you to take the money in a lump sum and start paying interest immediately. HELOCs, on the other hand, offer more flexibility but come with variable rates that could increase significantly over time. Given these differences, new homeowners should carefully evaluate their needs and financial situation before choosing between these options.
Misunderstanding variable interest rates
With HELOCs in particular, new homeowners don’t always fully grasp how variable rates work. These rates typically adjust based on the prime rate, which means your monthly payments could increase substantially if rates rise. So while today’s HELOC rates might seem manageable, it’s crucial to calculate whether you could still afford the payments if rates were to increase significantly in the future.
Consolidating debt without addressing spending habits
Many homeowners use home equity to consolidate high-rate debt, which can be a smart financial move in many cases. However, this strategy backfires if you haven’t addressed the spending habits that led to the debt in the first place. Without changing these behaviors, you risk running up credit card balances again while also carrying home equity debt, potentially putting your home at risk.
The bottom line
The decision to borrow against your home’s equity should never be made hastily or without careful consideration of your overall financial picture. For new homeowners, taking the time to understand these common pitfalls and how to avoid them can help ensure that home equity borrowing strengthens rather than weakens their financial foundation. Remember that your home equity represents years of investment and financial discipline – treat it with the respect it deserves.