Pros and Cons of Using a Home Equity Loan for Debt Consolidation
Borrowing against the equity you’ve built in your home is a major financial decision that includes a few risks, especially if you’re considering a home equity loan for debt consolidation. After all, if you default on the payments, you could lose your home to foreclosure.
However, if you have stable employment and income, and you’re confident in your ability to make monthly payments, using a lump-sum home equity loan to pay off debt can be a viable option to streamline your finances.
What is a home equity loan?
A home equity loan is a type of second mortgage that allows you to borrow against the available equity in your home. Home equity is the difference between how much your home is worth and any loan balances on the property. A home equity loan is secured by your home, paid out in a lump sum and typically comes with a fixed interest rate and monthly payment amount.
Home equity loan terms often range from five to 30 years. Common uses for the funds include making home improvements, covering college expenses, starting a business or consolidating higher-interest debt.
When you take out a home equity loan for debt consolidation, you’re cashing in a portion of your equity to pay off non-mortgage debt. You’re also exchanging several monthly debt payments with varying interest rates for one payment with a fixed interest rate.
Pros and cons of using a home equity loan for debt consolidation
You may secure a lower interest rate than with other forms of financing. A home equity loan is a secured loan, and these types of loans generally have lower interest rates than unsecured loans. For example, interest rates on personal loans, which are unsecured, can range from 5% to 36%, according to ValuePenguin data. By contrast, home equity loan rates can range from about 2.5% to 10%.
You can consolidate multiple debt obligations into one monthly payment. A major perk of using a home equity loan to pay off debt is the simplicity it adds to your debt repayment strategy. Instead of trying to track multiple payments for credit cards, loans and other types of debts, you can roll all your debts into a single payment through a home equity loan. This makes it easier to manage your monthly obligations.
You may receive more affordable payments and get rid of your debt faster. Since home equity loans tend to have lower interest rates than many other financial products, you could save thousands in interest payments after consolidating your debt. Additionally, with a lower rate, a larger portion of your payment will go toward reducing your principal balance each month. You could also get out of debt sooner by choosing a shorter repayment term. If you’d like lower monthly payments on your debt you could choose a longer term, though you’ll pay more in interest over time.
You risk losing your home to foreclosure. Your home is used as collateral on a home equity loan, which means that if you fail to make payments, your lender can repossess your home through the foreclosure process. You’ll also take a hit to your credit in the process.
You won’t be able to deduct interest paid on the home equity loan. When you use home equity loan funds to pay for anything other than home improvements, you’ll lose the ability to deduct the mortgage interest you pay on the loan from your federal tax bill.
You’ll pay several fees, including closing costs. It costs money to borrow money, which applies to tapping your home equity. Taking out a home equity loan involves getting a home appraisal to verify your home’s value, which costs $300 to $400. You’ll also have other home equity loan closing costs, including loan origination and title fees.
You’re increasing your debt load. You’re borrowing more debt to pay off other debt, which increases your debt-to-income (DTI) ratio. A DTI ratio tells you the percentage of your gross monthly income that is used to repay debt, and is used to determine your eligibility for loans, credit cards and other forms of credit.
5 alternatives to a home equity loan to pay off debt
If you’re not convinced using a home equity loan for debt consolidation is your best option, take a look at the below alternatives.
A home equity line of credit (HELOC) is another type of second mortgage. Instead of a lump sum, a HELOC is a revolving credit line that works similarly to a credit card. You can withdraw from the line of credit as needed, repay it and withdraw from it again. Additionally, you only make payments based on what you withdraw, plus interest.
Key HELOC takeaways:
- It’s a revolving credit line instead of a fixed-rate loan
- It’s secured by your home
- Generally has a variable interest rate
Balance transfer credit card
If you have strong credit, you may be eligible to transfer your balance from a high-interest credit card to one with an introductory 0% annual percentage rate (APR) for a set time. Some credit cards will allow you to transfer a balance with no fees and allow payments without interest for up to a year or longer, which can buy you time to pay down the balance minus extra fees.
Key balance transfer card takeaways:
- It may feature a 0% APR for a predetermined period
- It can include upfront balance transfer fees
- It may not be the best option for borrowers with high amounts of debt
Personal loans are typically unsecured, which means they don’t require collateral like a car loan or home equity loan does. It also means interest rates are higher to account for the additional risk involved. Borrowers with good credit scores may qualify for a personal loan that has a lower interest rate than their current debts, such as on credit cards, but the rate will likely still be higher than the rate for a home equity loan.
Key personal loan takeaways:
- It’s an unsecured loan that doesn’t require collateral
- It typically has a higher interest rate than a secured loan
Debt management plan
In some cases, going through a nonprofit credit counseling agency can be a feasible option for consumers who want to manage their debt without tapping their home equity. Credit counselors set you up on a debt management plan (DMP) that has a single payment each month, but they can also try negotiating with creditors to lower interest rates.
Key debt management plan takeaways:
- It’s arranged through a credit counseling agency
- It may lead to lower interest rates on your debt load
- It can take up to five years to complete
If your debt is too overwhelming to manage, you may need to consider filing for bankruptcy. Major drawbacks of this option include the high costs involved and the damaging effects it has on your credit history. Bankruptcy can stay on your credit report for seven to 10 years, depending on which type you file. Due to the consequences, bankruptcy should be a very last resort.
Key bankruptcy takeaways:
- It negatively affects your credit reports and scores for an extended time period
- It can prevent you from qualifying for a new mortgage before you complete a set waiting period