Using a Home Equity Loan for Debt Consolidation
What is home equity?
Home equity is the part of your home’s value that exceeds the amount you owe on your mortgage. Equity builds over time as you make payments to your principal, and also grows as your home appreciates. To estimate how much home equity that you have in your home, simply subtract the remaining balance on your mortgage from the total value of your home. For example, if you own a home worth $250,000 but you owe $175,000 on the mortgage, your home equity equals $75,000. When you sell your house, you receive that difference. Sometimes you don’t have to wait until you’ve sold your home to access that profit. You may be able borrow against it while still living in the house. This makes it available to help you get out of debt.
Options for home equity
If you decide to use your home equity to consolidate your higher-interest debts, there are two different types of loans to look into.
1. A home equity line of credit (HELOC)
With a HELOC, your lender advances you whatever amount of money you desire, up to your credit limit. As you need money, you can get it using special checks attached to the loan account. On a HELOC, the interest rate is usually adjustable, and you pay interest only on the amount that you withdraw. HELOCs are appropriate for uses that require payments over a time period, such as college tuition or home improvements, but they are not the ideal option for debt consolidation.
2. A home equity loan (HEL)
A home equity loan for debt consolidation is the better route. A HEL, also called a second mortgage, lends you a lump sum and has a fixed interest rate. You also make monthly payments on the HEL, just like you do on your first mortgage. HELs usually work better when you need the money all at once, like in the case of debt consolidation.
There is a formula that lenders use to determine how much of your home equity they feel comfortable lending you. In the following example, a home that has been appraised at $150,000 and has an outstanding balance of $50,000 would yield $70,000 for the borrower. See below.
|Appraised value of home||$150,000|
|Multiplied by LTV of 80%
($150,000 x 0.80)
|Subtract existing mortgage
($120,000 – $50,000) for amount of home equity loan
Reducing debt through home equity
If you decide to get a home equity loan to get out of debt, this is how it would work: You take the cash from your home equity loan and use it to pay off your creditors. Then, you repay the home equity loan through fixed monthly payments. Each month, you should have significant savings in interest payments because the home equity loan is secured with your home as collateral. This savings should enable you repay the debt more quickly and, thus, help you get out of debt.
A word of caution
There are several points to remember if you decide to use home equity to get out of debt. First of all, since the loan is secured by your house, you can lose your home if you default. Most lenders will work to try to avoid this, but it is a big risk. It is best to be very sure that you can make the payments before getting a home equity loan. Also, if you do not become disciplined in your spending, you may acquire more debt and be worse-off than you were before. If you rack up more debt on high-interest credit cards, you’ll have basically wasted your home equity. It is vital to stop creating new credit card debt. That is the only way to stay out of debt.