Using Your Home’s Equity to Consolidate Debt
Debt can be suffocating when you’re buried under it. Luckily, you may be able to tap your home equity to consolidate debt and help you move toward financial freedom.
Here’s a look at how this debt consolidation option works, its pros and cons and other options you may consider.
- What is home equity?
- Using your home equity to consolidate debt
- Differences between a home equity loan and home equity line of credit
- Pros and cons of using a home equity loan for debt consolidation
- Other options for consolidating debt
- Making the best choice for you
What is home equity?
Home equity is the difference between the value of your home and how much you owe; equity represents how much of your home’s value you own. Over time, as your home’s value increases and the loan balance decreases, your equity rises.
“You can think of it as a teeter totter,” said Todd Christensen, an accredited financial counselor with Money Fit by DRS, “with your home and its value on one side and the lender and your mortgage balance on the other.” Both sides are basically even at the time of home purchase, he said. Over time, as you make mortgage payments and as your home value generally goes up each year, the side of the with your home on it starts to outweigh the side with your balance. Once you pay off the mortgage completely, you have 100% equity in the home.
Using your home equity to consolidate debt
Debt consolidation works to simplify your debt repayment plan so that you have just one payment a month, rather than one for each of your multiple accounts. Christensen notes two basic types of debt consolidation plans: a debt consolidation loan, and a debt management plan through a nonprofit credit counseling agency.
“A debt consolidation loan means you open a new loan that pays off all of your other loans so that you now only have one account you pay each month,” Christensen explained. Consolidation can make repayment easier by reducing the number of bills you’re paying each month. A lower rate and shorter repayment term could also reduce your monthly payments.
Two types of debt consolidation loans are backed by home equity: home equity loans (HEL) and home equity lines of credit (HELOC). It’s important to know the differences between them to understand why a home equity loan might be the better option for debt consolidation.
Differences between a home equity loan and home equity line of credit
There are some key differences between home equity loans and HELOCs. But they also have one big similarity: They’re both secured by your home equity. Bear in mind too that lending institutions typically limit the maximum percentage of home equity you can borrow to around 80% to 85%.
Beyond that, there are important differences:
Which is better for debt consolidation? Consolidating debt should make repayment easier, whether you’re looking to pay off debt sooner or just reduce how much money you’re putting toward your monthly dues.
According to Christensen, a home equity loan might be preferable to a HELOC for debt consolidation, “since it sets a monthly repayment amount and an end date to the loan.” Because a HELOC comes with a variable rate, your monthly payments can change from one month to the next, making it harder to map out your repayment. A HELOC may also come with a higher interest rate overall.
And, because it’s a line of credit, a HELOC may come with the temptation to add to your debt balance. You won’t have that issue with a home equity loan.
Pros and cons of using a home equity loan for debt consolidation
Borrowing against your home’s equity may be an affordable option for needs such as debt consolidation, noted Jon Giles, head of home equity at TD Bank. However, it is important to weigh the pros and cons.
“Prior to applying,” he said, “borrowers should understand their responsibilities and the risks.” Take the following into consideration.
Lower your interest rate and costs: The interest rates of home equity loans are lower than the average credit card interest rate, which Christensen pointed out is around 16%; “this means you will pay much less in interest over time,” he noted. Giles echoed this advantage: “By using the home as collateral for a loan, the borrower typically can get a lower rate, a lower payment and qualify for a higher loan amount than with other forms of credit.”
Simplify your payments: A single monthly payment can be much easier to manage than multiple payments due throughout the month. “Additionally,” said Christensen, “you can automate your payment with your bank or credit union so that the HEL gets paid without you even stressing about it.”
Pay off your accounts: While enhancing your creditworthiness might be important to you over time, Christensen noted that the impact of taking out a home equity loan to consolidate debt may be minimal, especially early on. Although you are paying off multiple accounts, you initially will have the same debt balance with the new home equity loan (and possibly higher if there are any loan processing fees). All of the paid-off accounts will remain listed on your credit history for the next seven years, though they will show a zero balance.
Find peace of mind: The feeling of knowing you are doing something about your debt may help you feel you’ve made a good decision and are in control of becoming debt-free.
Using your home as collateral: This might be your most important consideration, a point Christensen expressed in a very practical manner: “The biggest con is that you have now put your home at risk for every payment you made on the accounts you are paying off. If you purchased a pizza with your credit cards that you are paying off with a HEL, and you start missing HEL payments, you can lose your home, in part, because of the pizza. No pizza is THAT good.”
Making your monthly payment: While you have paid off your credit card or other accounts with your loan proceeds, it’s important to understand you still have to make the monthly payment on your home equity loan. “Borrowers should understand their budget, and any future financial needs, to ensure the payment is acceptable during the entire term of the loan,” said Giles.
Tax law changes: As Christensen noted, the 2017 Tax Cuts and Jobs Act affected tax deduction benefits of home equity loans used for debt consolidation. The IRS allows homeowners to deduct interest if home equity loans or HELOCs are used to “buy, build or substantially improve your home,” but not if used to consolidate debt, he said.
Other options for consolidating debt
You don’t have to tap your home equity to manage debt. Here are two other viable options if you have good credit.
Personal loan: Christensen called this option “the epitome of a debt consolidation loan.” Though he acknowledged that it will carry a fairly high interest rate, depending upon your current credit rating, he also noted that it may still be less than your credit card interest rates.
He cautioned, however, against running your credit card balances back up to their original levels after paying them off. More than half of consumers do this within two years, he said, and it leads to nearly doubling your debt. “Create a spending plan, shred the cards, and avoid future consumer debts,” he advised.
Balance transfer cards: Credit card balance transfers can be an effective way of simplifying your monthly debt repayment plan. By transferring all of your current debts onto one credit card, you will have only one monthly payment going forward.
However, Christensen did offered a caution. “Keep in mind that a credit card balance transfer typically carries a transfer fee of 3% to 5%. So for every $1,000 you transfer, you will pay $30 to $50 in fees.” He also recommends keeping zero balances on the cards you have paid off and always paying more than the minimum payment due on the transfer card.
Making the best choice for you
You don’t have to borrow against your home equity in order to consolidate debt. However, if you’re confident in your ability to repay it, a home equity loan could be a solid option thanks to its low interest rates.
You have other options for consolidating your debt, however. You may consider a balance transfer card or personal loan, for example, if you’re not comfortable risking your home for lower rates.
Don’t be afraid to reach out for expert help if you’re unsure of which option is best for you. As Giles noted, “Homeowners should consider speaking with a lender to discuss the right options for their unique financial situation and fully understand how using a HELOC or a home equity loan to consolidate outstanding payments could impact their finances in the short and long term.”