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Using a Home Equity Loan for Debt Consolidation
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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.
A home equity loan is a type of second mortgage that allows you to borrow against the available equity in your home. 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.
Pros of using a home equity loan for debt consolidation
You may have an interest rate that’s lower than other loan types. 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 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.
You may get more affordable payments and pay off 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 using home equity to pay off debt. Additionally, 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
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 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 costs $300 to $400. You’ll also have other home equity loan closing costs, including loan origination and title fees.
You’ll likely experience closing delays. It typically takes two to four weeks to close a home equity loan, but in a low interest-rate environment where there’s an influx of lending activity and home appraisers are overwhelmed, there could be a delay in your closing time.
You’re increasing your 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.
5 alternatives to a home equity loan for debt consolidation
If you’re not convinced 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 — during the draw period, which may last 10 years. Additionally, you only make payments based on what you withdraw, plus interest.
Key HELOC takeaways:
- It’s a revolving credit line instead of a loan
- It’s secured by your home
- It 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 make 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 car loans or home equity loans do. It also means interest rates are higher 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.
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