Home Equity Loans For Debt Consolidation

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In the first quarter of 2018, for the 15th straight quarter, aggregate balances for household debt in the U.S. increased, rising to $536 billion more than they had been in Q3 2008.

But wait, there’s more. A report by the New York Fed in March 2018 showed student loan debt growing by $29 billion and auto loan balances increasing by $8 billion, all within the first quarter of 2018.

There’s… still more. Data show that credit card balances as of the end of 2017 for the 40-49 age group were higher than they’ve been since 2011. For 30-39 and 50-59 age groups, credit card balances are higher than they’ve been since 2009.

Put all of these startling statistics together with the fact that credit card interest rates are heading close to levels not seen since the 1990s and you’re looking at a financial atmosphere pushing many people toward considering a variety of debt consolidation options, including a home equity loan. The problem is, this decision carries significant risks, so carefully consider them before borrowing.

What is a home equity loan?

Home equity is the difference between what the homeowner owes on the home through mortgages and loans, and the market value of the property. For example, if a house has a $350,000 market value and an outstanding mortgage of $200,000, the home’s equity is $150,000.

Two common ways homeowners access this equity and use it for other spending are through home equity loans or a home equity lines of credit (HELOCs). With a home equity loan, they will receive a lump sum with a fixed interest rate and a fixed monthly payment. With a HELOC, on the other hand, a homeowner gets a revolving line of credit that accesses equity. HELOCs allow for disbursements as needed, but often have adjustable interest rates that can rise or fall, making payments somewhat unpredictable.

Getting a home equity loan or line of credit isn’t a free-for-all, giving you unquestioned access to all your equity. Generally, homeowners are permitted to borrow only up to 85% of a home’s value. Using the example above, our $350,000 homeowner with $150,000 equity would then be eligible to borrow up to $127,500. But first, they need to qualify.

Qualifying for home equity loans

You’ve probably figured out that having equity in the home is the first obstacle to qualifying for a loan, but there’s more to it than that. Even though the loan is secured by your home, a lender still wants to make sure that you have the ability to repay the loan. In addition to looking at your income, assets and employment to determine ability to repay, they’ll look at your credit history to see how you’ve been paying other accounts you have.

Another consideration that’s especially important for those considering using a home equity loan to consolidate debts is the debt to income (DTI) ratio. This is the overall relationship between your income and your debt payments. For example, if your monthly income is $5,000 and your current monthly debt payments are $2,500, then your DTI ratio is 50%. Each lender may have its own requirements for DTI ratio, but many want a borrower’s DTI to be less than 43%.

Benefits and drawbacks of home equity loans for debt consolidation

Benefits

When you take out a home equity loan for debt consolidation, you are essentially cashing in on your equity and using that to pay off multiple other debts. Then, instead of making payments on those individual debts each month and being charged individual rates of interest, you have just the home equity loan payment to cover and are only being charged that single interest rate.

One of the biggest benefits to this, according to Mike Molitoris, MIMFA, CRPC and managing director of Flagship Wealth Management Group, is the lower interest rate you can get with a home equity loan, as compared to the rate on credit cards. “You may have the opportunity to shave off anywhere from 10 or more percent of what you’re paying,” said Molitoris.

The potential cost savings of using a home equity loan for debt consolidation doesn’t stop with reducing that interest rate. According to Harvey Bezozi, CPA, CFP and founder of YourFinancialWizard.com, the home equity loan may also give you some bargaining power with your creditors. He advises that home equity loan borrowers negotiate with their creditors before paying them off. “When you tell then you want to pay it off, you can get them to strike a deal with you,” said Bezozi.

Drawbacks

One of the most significant disadvantages is the fact that you’re using your home as collateral. “Drawback number 1 is that your house is on the line. That’s a biggie,” said Molitoris. If you’ve used the equity to consolidate credit card debt, then it also means you’ve taken previously unsecured debt and secured it with your house. If you later run into financial trouble, your house is on the line if you can’t make your home equity loan payments.

In the past, one benefit of taking out an equity loan to consolidate was that some of the interest on the loan could be tax deductible — now, that’s no longer the case. The interest you pay on a home equity loan is only potentially tax deductible if the proceeds of the home equity loan are used to make material improvements to your home.

Is a home equity loan right for me?

Fully grasping the benefits and drawbacks of using a home equity loan for debt consolidation may not help in actually answering the question of whether it’s the right decision for you. The very first thing you want to do is compare the cost of the consolidation — including interest and fees — with the cost of your debt.

“The big thing is, is it really going to save [you] money,” said Molitoris.

It’s not enough to assume that a lower interest rate on an equity loan will make the difference, because a long-term loan on a large amount can result in higher overall interest accumulation than you might expect.

For example, if you had $15,000 in credit card debt with an average interest rate of 16%, making a $300 payment each month would see you paying $9,883 in interest over close to 7 years. If instead, you had a 5-year equity loan of $15,000 with an interest rate of 5.79%, your monthly payment of $288.53 would repay the loan in just 5 years with total interest costs of $2,311.77.

But let’s say you decide to stretch that out to a 20-year loan with a monthly payment of $111.31 and an interest rate of 6.44%. That total interest rate may be lower than the rate on your credit cards, but in the long term, that results in interest charges of $11,713 — more than if you’d kept the credit card debt as-is.

Another point to factor in is the negotiating power that Bezozi mentioned an equity loan can give you. If you have the cash to pay off your credit card debt through an equity loan, that may give you some room to bargain with creditors to lower your overall debt and save even more.

“If you feel like your tires are just spinning every month, then you may need to look at the debt consolidation angle. If you’re a person who needs structure, maybe restructuring and having just a simple payment is worth it,” said Molitoris.

Accordin to Bezozi, an equity loan is the last resource to consider. “If there’s no other option and you really want to get out from underneath the credit card debt, you can use a home equity loan because the interest rate is lower, and hopefully the house is appreciating so you’ll get even more equity in the future,” he said. “But if you get the equity out and your house goes down in value, you’re upside down.”

Alternative options to consolidate debt

Before tying up home equity to consolidate debt, it’s worth considering other options. The first thing you should do, according to Molitoris, is to look at the cash you have available. “Some people sit on large amounts of cash and run up debt. It doesn’t make sense to get paid 1% [on savings] when interest on your debt is 15%,” said Molitoris. If you don’t have any cash stashed away, you can consider:
  • Personal loans

    Banks, credit unions, and even online peer-to-peer lending sites can all offer the resources to secure a personal loan with no collateral. But make sure to watch the interest rates, as they may be higher on unsecured loans. Alternatively, you can ask friends and family for loans.

  • Debt management plans

    In some cases, using a credit counseling agency can be a good step for consumers who want to manage their debt without tying up home equity. Not only can credit counselors set you up with a single payment each month, but they can also negotiate with creditors to lower interest rates.

  • Bankruptcy

    If debt has become something you can’t keep up with, then bankruptcy might be an option. However, the cost of bankruptcy, combined with the possible loss of assets and impact to your credit, makes this an option many people want to avoid.

  • Using retirement savings

    If you’ve been contributing to an IRA or an employer-sponsored retirement plan, then you might consider taking a loan or distribution from the account to pay off your debts. But doing so carries several big risks, including locking in losses when you liquidate holdings, missing out on earnings, triggering taxes and penalties, and facing accelerated repayment if you leave your job.

Coming back from consolidation

However you decide to deal with debt consolidation, you need to have a plan for making sure you don’t repeat the actions that created the problem in the first place.

“Homeowners have to have a reality check,” said Molitoris. “Is this the first time they’ve done this? Have they [consolidated] before and then turn around and run [the cards] right back up? If that’s the case, then they’re basically recycling a bigger problem that exists.”

Molitoris suggested examining the nature of this potential spending problem. Further, he suggested bringing on an accountability partner to help hold you accountable for spending after consolidation.

Frequently Asked Questions

Borrowing against a home equity loan is a big step, as it can erase debt a homeowner has spent years paying off and risk foreclosure if the homeowner defaults on the loan. However, for homeowners who have stable work, can control their spending, and are committed to paying off debt, a home equity loan can be an excellent way to reduce debt faster.

Yes. Because home equity loans require that borrowers put up their home equity as collateral, defaulting on the loan would result in the bank seizing the house. Home equity loans can be an excellent option for homeowners who are confident that they can make the monthly payments on the loan, but homeowners who aren’t sure about their job stability and ability to make loan payments may want to weigh carefully the benefits of a home equity loan to consolidate debt over the risk of losing their home.

To calculate savings, homeowners should compare their current debt, interest payments, and length of the loans to the terms of a home equity loan. Even if a home equity loan will require a much longer payment period, the savings in interest payments could make it worthwhile.

Debt relief calculators can help you determine how much you can save with a home equity loan.

Interest rates remain at long-time lows, making now an ideal time to apply for a home equity loan.

Before applying, homeowners should shop around different lenders and ask about rates and terms for home equity loans. Talk to banks, credit unions and mortgage companies and compare their loan plans. Some lenders will negotiate some fees, and you can ask one lender to offer fees comparable to another. After you get quotes for multiple loans, look at interest rates, repayment terms, fees and closing costs to choose the one that suits you best.

Here are a few other ways to pay off high-interest debt:

HELOC: A home equity line of credit (HELOC) is an alternative to a home equity loan that works like a credit card. Instead of receiving the loan in a lump sum, borrowers with a HELOC withdraw only as much money as they need at the time. In return, the homeowner only makes monthly payments and interest on the money withdrawn so far, not on the entire amount of the line of credit. Money can be withdrawn through debit cards or checks.

HELOCs typically have more repayment flexibility than home equity loans. Some HELOCs allow interest-only payments for a specified period, but when the repayment period ends, the borrower is expected to fully repay the balance due on the line of credit.

Like home equity loans, HELOCs may require fees or closing costs. And they generally carry variable interest rates, which make payment amounts less predictable.

Personal loans: If you have a good credit score, you may qualify for a personal loan that has a lower interest rate than your current debts. Rates can be as low as 5 or 6 percent for borrowers with good credit. Personal loans and other unsecured credit options may be a good option for anyone turned off by a home equity loan or HELOC because of the possibility of losing their home.

There are also secured personal loans, which will have lower interest rates than unsecured personal loans, which require collateral. Borrowers can use a car or other valuable items as collateral rather than their house.

Balance transfers: If you have a credit score greater than 700, you may be eligible to transfer your balance from a high-interest credit card to one with a an introductory 0% interest rate for a specified time. Some credit cards will allow you to transfer a balance with no fees and allow payments without interest for as many as 15 to 24 months, which can buy you time to pay down the balance without paying interest.

Debt avalanche strategy: If you decide not to take out a loan, rearranging your budget can help you speed up your debt repayment. The debt avalanche strategy involves putting as many resources as possible toward your highest-interest debt, and when that is paid off, apply those resources to the next-highest-interest debt, and so on.

A key to paying off any kind of debt is understanding why you have debt and exercising self-discipline while you pay off the existing debt. That may mean cutting back on spending, forgoing vacations, or taking on another job while you focus your resources on paying down debt. Getting out of debt can be worth the work as you rein in spending, stick to a budget, and reap the emotional and financial rewards of paying off what may have seemed like insurmountable debt.

Disclaimer: This article may contain links to MagnifyMoney, which is a subsidiary of LendingTree.