Does it make sense to use your home equity to consolidate debt?
When you have too much debt, it can be hard to know how to find relief. Using your home equity -- the part of your home that you own -- can be a helpful way to get out of debt.
Equity builds when you pay down the principle of your mortgage and/or your home appreciates. It is important to understand how you can use your equity for debt consolidation to evaluate whether it’s a good option for you.
What are the options for using home equity?
Home equity loans and home equity lines of credit are two ways to tap into your home equity. A home equity loan is the better option when it comes to consolidating debt.
1. Home equity line of credit (HELOC) – A home equity line of credit works like this: The lender advances you money, capped at an amount they set. You can then access the money whenever you need it, typically through special checks. You only pay interest on the amount that you withdraw, and the interest rate is usually adjustable. HELOCs are usually more appropriate for uses that require payments over a time period, such as college tuition or home improvements.
2. Home equity loan (HEL) – A home equity loan works well for debt consolidation. It means that you are getting a second mortgage using your home equity. You borrow a one-time sum, get a fixed interest rate and are obligated to make monthly payments. HELs usually work better when you need the money all at once, such as debt consolidation.
The following formula is used by lenders to determine how much of your home equity they will lend you. On a home that has been appraised at $150,000 but the owner only owes $50,000 on the mortgage, the borrower would be eligible to receive a home equity loan of $70,000. The equation works as follows.
|Appraised value of home||$150,000|
|Multiplied by loan-to-value ratio (LTV) of 80%
($150,000 x 0.8)
|Subtract existing mortgage
($120,000 – $50,000)
Is it the right move for me?
Maybe you are considering a home equity loan to pay off your debt, but you still are not quite sure if it is the right move for you. Isn’t it just paying off one debt with another? In a sense, the answer is yes, but that does not mean that it is not a smart decision. Consider the following questions to guide you as to whether debt consolidation using home equity makes sense for you.
- Are you paying high interest rates on your credit cards or car loan?
- Are interest rates low for second mortgages?
- Do you have considerable home equity so that if you use some to pay off debt you still have enough left over if you decide to sell your home?
- Can you be disciplined about your spending and not rack up more debt once you’ve paid off this debt?
If you answered yes to all or most of these questions, then it may make sense for you to use your home equity to pay off your debt. The final question is very important, however. You have to be able to restrain your spending or else you will just fall into the trap of more debt. If you can be disciplined, then using your home equity for debt consolidation may be a good option for you.
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