If you are drowning in debt, using your home equity for debt consolidation can be the life preserver that you so desperately need. Understanding how to use your home equity for debt consolidation can not only help you to get a handle on your current finances, but also help you to manage it better in the future.
What is home equity?
Home equity is the part of the home that you own. You build equity by either paying down the principle on the mortgage, or by your home’s value appreciating. To estimate how much home equity you have in your home, simply subtract the remaining balance on your mortgage from the total value of your home. For example, if you have a home valued at $250,000 and owe $150,000 on the mortgage, your home equity equals $100,000. When you sell your house, you receive that difference. However, you are able to use your home equity by borrowing against it while still living in the house. This makes it available for debt consolidation.
How can home equity help to consolidate debt?
If you have a high debt load of credit card debt, car debt, etc., your home equity can bring you some relief. Unsecured debts like these typically carry high interest rates. That means, you can spend a considerable amount of money each month on interest payments and still be doing nothing to reduce your debt load. By consolidating your debt using your home equity, you will be paying less interest and, therefore, can pay the debt off more quickly.
What are the options for using home equity?
If you decide to use your home equity to consolidate your debts, you have a couple of different options, with one being better than the other.
- Home equity line of credit (HELOC) – When you take out a home equity line of credit, a lender advances you an amount of money up to your credit limit. You get that money as needed and typically access it through special checks attached to the account. The interest rate is usually adjustable, and you pay interest only on the amount that you withdraw. However, HELOCs are usually more appropriate for uses that require payments over a time period, such as college tuition or home improvements.
- Home equity loan (HEL) – A home equity loan is usually the better option for debt consolidation. It involves getting a second mortgage using your home equity. You borrow a lump sum and have a fixed interest rate. You also make monthly payments on the HEL. HELs usually work better in a situation where you need the money all at once, such as with debt consolidation.
How is home equity used to consolidate debt?
Lenders use a formula to determine how much of your home equity is available to you to use as a home equity loan. For example, on a home that has been appraised at $150,000 where 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 (LTV) ratio of 80 percent
($150,000 x 0.80)
|Subtract existing mortgage
($120,000 – $50,000)
This means that the borrower in this situation could get a home equity loan for up to $70,000.
If you determine this method of debt consolidation is right for you, you use the home equity loan to pay off your creditors and then repay the second mortgage to your lender. You should save a significant amount in interest payments, and also have the convenience of your debts being wrapped up into one payment. Also, the interest on your home equity loan should be tax deductible. (Be sure to check with your tax advisor).
One key point to remember is that your debt is now in your second mortgage, so it is secured with your home. If you default on the loan, you can lose your collateral (your home). Therefore, it is very important to look at all variables when considering using your home equity for debt consolidation, and be sure you can make your monthly payment.