Carrying around high-interest debt can be tough on your finances. Even with regular payments, you never seem to make a significant dent in the principle balances. If you want to consolidate your bills into one manageable payment with lower interest, a home equity line of credit (HELOC) might be the right move for you.
"A HELOC is secured by the equity you have in your home," explains David Reiss, professor of law and writer of REFinBlog. "It's a line of credit that you can borrow from at any time within the loan's term, but because it's revolving, it's sort of similar to a credit card, rather than a traditional home loan," he says. The money is there when you need it, but you don't have to borrow it. As such, many people use a HELOC for debt consolidation, since it usually significantly lowers the interest rate as they work to pay off their debt. There's also a tax benefit. "Typically, home interest payments are tax deductible, so that can be beneficial for those that itemize their deductions," says Reiss.
Although a home equity line of credit can be a great solution for your debt problems, run through this checklist first to be sure it will work for you:
1. Are You Committed to Fixing Your Debt Problem?
"People often get into debt because they're buying nonessential things. Moving your debt to your home equity might feel like a solution, but if you have a problem with spending, you're just borrowing from your future self," says Reiss. And while unpaid credit card bills can do damage to your credit report and result in judgments against you, if for some reason you are unable to pay your home loan in the future, you risk foreclosure.
Making it work: Whether you spent more than you should have in the past or had some bad luck, the first step toward improving your financial situation is to take a close look at your income and expenses. Ideally, you should be able to pay all of your essential bills and have some cushion left over for unexpected expenses. This might require making some cuts to your discretionary spending, and sticking to a stricter budget. "Having a plan and a realistic assessment of your own behavior and the extent to which it might have to be modified is a key to successful debt consolidation," says Reiss.
2. Will You Qualify?
It's not a given that you'll get approved for a home equity line of credit just because you're a homeowner. "The lender will look at the same criteria that they look for when you apply for a mortgage. If your credit score is messed up because of all your debt, it could affect your ability to qualify or get a good interest rate," says Reiss. It will also depend on how much equity you have in your home before you apply. "The closer you get to a loan-to-value ratio of 100, the much less likely you'll find someone to lend to you," says Reiss. Conservative lenders like to see that you have at least 20 percent equity in your home, but you might find others that offer more wiggle room.
Making it work: Check your credit score and take a look at your mortgage statement to see what the outstanding principal is on your main home loan. If you feel confident at that point, you can begin shopping around.
3. Do You Understand How HELOCs Work?
As you begin to research lenders, make sure you understand that HELOCs work differently than other lending products you've used before. "You want to understand the loan term. How long is it? When do you have to start paying back in full?" says Reiss. In addition, the interest rate is typically tied to the prime rate, and is adjustable. So even though the interest rate is favorable right now, it might rise over the next few years, and therefore, increase your monthly payment. "Ask yourself: 'Am I going to be able to pay if there is a skyrocketing change in the interest rate environment?'" says Reiss. Be sure to find out if the HELOC you're considering allows you to lock in a fixed rate at some point during the term.
Making it work: No matter how long the term or how low the minimum monthly payment, your aim should be to pay down the debt as fast as you can. "If you can clear out the debt sooner, you will be in better shape," says Reiss.
4. Are You Ready to Do Some Legwork?
"Anytime you make any big changes in your financial life, you want to be very careful and do your due diligence," says Reiss. "There are lots of shady operators in the financial services space. If people are pushing you to do this, make sure that what's being sold to you is a good deal," he says.
Making it work: "Don't just sign up from the first mailer you get from a lender or bank," says Reiss. "Talk with three or four financial institutions, and compare their offers. Just like when you shopped for a home mortgage, you want to be sure you're getting the best product for your needs. Compare rates, origination fees (if any), and terms," he adds.
Paying off your high-interest debt and getting a tax benefit sounds like a win-win. Plus, there is some comfort in knowing that the HELOC funds are available should you ever need them. As long as you move forward with good intentions and follow through on your payoff plan, a HELOC can prove to be a wise financial decision.