Using home equity to consolidate debt can be a good option. However, you need to carefully consider the pros and cons to know whether this is right for you.
What is home equity?Home equity is the part of the home that you own. You can build equity by paying down the principal on the mortgage, or by your home’s value appreciating. To estimate how much home equity is in your home, subtract the remaining balance on your mortgage from the total value of your home. For example, if your house is valued at $200,000 but you still owe $150,000 on the mortgage, your home equity equals $50,000. When you sell your house, you receive that difference. However, you might be able to use your home equity by borrowing against it while still living in the house. This makes it available for debt consolidation.
What are the options for using home equity?There are two ways to borrow against your home’s equity.
1. Use a home equity line of credit (HELOC) – In this case, a lender advances you a sum of money, with a predetermined ceiling. You can use the money as you need it and access it through special checks attached to the account. The interest rate on a HELOC is usually adjustable, and you only pay interest on the amount you withdraw. While this is good in some cases, like when paying for something over time, such as college, HELOCs are usually not the best option when it comes to consolidating debt.
2. Take out a home equity loan (HEL) – This option makes more sense for debt consolidation. It involves getting a second mortgage using the equity in your house. With this type of loan, you borrow a lump sum, have a fixed interest rate, and make monthly payments to repay the debt. HELs usually work best when you need money all at once, like you do when you’re consolidating debt.
How much can I get?Lenders use a formula to determine how much of your home equity they will make available to you through a home equity loan. For example, on a home that has been appraised at $150,000 but the owner only owes $50,000 on the mortgage, the equation would work as follows:
|Appraised value of home||$150,000|
|Multiplied by loan-to-value ratio (LTV) of 80 percent
($150,000 x 0.08)
|Subtract existing mortgage
($120,000 – $50,000)
Therefore, the person in the above example has access to $70,000 in cash from a home equity loan.
Is it right for you?You can see that it can make a lot of sense to use home equity to consolidate debt. However, if you are not completely sure if you’re a good candidate for this type of loan, consider some of the following questions:
- Do you have high interest payments on your credit cards and car loan?
- Can you get a good rate on a home equity loan?
- Are you able to be disciplined about your spending so you don’t acquire even more debt?
- If you sell your home, will your payoff be enough to pay the home equity loan in full plus have enough leftover for a down payment on your next home?
If you can answer yes to all or most of these questions, then perhaps using home equity for debt consolidation is smart for you. Create a financial plan that uses your home equity to get out of debt and be sure to stay out of it in the future.