Using a Home Equity Loan for Debt Consolidation
A home equity loan is a type of second mortgage that allows you to convert the available equity in your home into cash. When you use a home equity loan to pay off debt, you’re cashing in your equity and exchanging multiple monthly payments — with varying interest rates — for one fixed interest rate payment.
Borrowing against the equity you’ve built in your home is a major financial decision that comes with some risks, however, including losing your home to foreclosure if your payments become unmanageable.
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Using a home equity loan to pay off debt: How it works
A home equity loan is a second mortgage, meaning that most homeowners will take out a home equity loan while they are still paying off their primary mortgage. You can borrow a lump sum of money with a home equity loan and use the cash to pay down your debts. You’ll then pay back the loan at a fixed interest rate over a set period of time.
How much you can borrow is determined by three main factors:
The interest rate you’ll pay is usually determined by the following factors:
Equity is the difference between how much you owe on your home and how much it’s worth. You’ll need at least 15% equity in your home to successfully qualify for a home equity loan.
Pros of using a home equity loan for debt consolidation
Lower interest rates. 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 used for debt consolidation, which are unsecured, range from 13.35% to 97.92% on average, according to ValuePenguin data. In contrast, home equity loan rates can range from about 6.13% to 6.38%.
Fewer payments to juggle. A major perk of using a home equity loan for debt consolidation is the simplicity it adds to your debt repayment strategy. Instead of trying to track multiple payments for auto, personal or student loans, credit cards and other types of debts, with a home equity loan, you can roll all your debts into a single payment. This makes it easier to manage your monthly obligations.
Lower monthly payments. Since home equity loans tend to have lower interest rates than many other financial products, you could save thousands in interest payments by trading out your high-interest debt for a home equity loan. Plus, a larger portion of your payment will go toward reducing your principal balance each month, due to a lower interest rate. You could also get out of debt sooner by choosing a shorter repayment term.
Cons of using a home equity loan for debt consolidation
Risk of foreclosure. Your home is used as collateral on a home equity loan — this means that if you fail to make payments, your lender can repossess your home through the foreclosure process.
Fees and closing costs. It costs money to borrow money, and that applies to using a home equity loan to pay off debt. Taking out a home equity loan involves getting a home appraisal to verify your home’s value, which often costs $300 to $500. You’ll also have other home equity loan closing costs, including loan origination and title fees.
Increasing debt load. You’re borrowing more debt to pay off other debt, which increases your debt-to-income (DTI) ratio. Your DTI ratio indicates the percentage of your gross monthly income being used to repay debt, and helps determine your eligibility for loans, credit cards and other forms of borrowing.
Risk of ending up “underwater.” When you take out a home equity loan, your equity shrinks. If for some reason your home value also dropped, it’s possible you could end up owing more on the home than it’s worth.
Loss of certain tax benefits. 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.
6 alternatives to a home equity loan for debt consolidation
If you’re not convinced that using a home equity loan for debt consolidation is right for your finances, take a look at the following 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 use a HELOC to pay off debt by withdrawing from the credit line, repaying it and withdrawing from it again as needed — but only during the draw period, which may last 10 years. In addition, during the draw period you might be able to make low, interest-only payments. However, once the draw period ends, you’ll have to start paying back everything you owe.
Yet another way to borrow money against your home equity is to pay off your first mortgage and take out cash at the same time using a cash-out refinance. This will replace your existing mortgage with a new loan that has new terms — and give you a lump sum of cash to pay off your debt.
Just keep in mind that you’ll need at least 20% equity and a 620 credit score to meet qualification requirements — and a score of 780 or higher if you want to get the best interest rates available. If you need a low-credit option, you can look into an FHA cash-out refinance backed by the Federal Housing Administration, but you’ll have additional costs in the form of FHA mortgage insurance.
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 make payments without interest for up to a year or longer, which can buy you time to pay off credit card debt — minus extra fees.
Personal loans are typically unsecured, which means they don’t require collateral like car loans or home equity loans do. This is great news if you’re not comfortable putting your home on the line in order to pay off your other debts. However, it also means you’ll have to pay higher interest rates, to account for the additional lending 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 credit cards, but the rate will likely still be higher than the rate for a home equity 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 your interest rates.
If your debt has become overwhelming, you may need to consider filing for bankruptcy. Although bankruptcy can help greatly — it can settle your debts for less than you owe and, in some cases, even improve your credit score — there are also some major drawbacks. The costs (including court fees) can be high, and the damaging effects it has on your credit history can last for seven to 10 years, depending on the type of bankruptcy you file. If you’re considering taking this step, it could help to speak with a credit counselor.