Is It Wise To Use A Home Equity Loan For Debt Consolidation?

Article Summary:

Using a low interest debt consolidation loan to pay off high interest debt is usually a smart move. Home equity loans provide long repayment terms and low interest rates, which make them an excellent debt consolidation loan. However, there are some risks to consider before you decide to apply for a home equity loan.

Is it wise to use a home equity loan for debt consolidation? If you have a significant amount of debt, using a home equity loan to consolidate can seem like an appealing option. A home equity line of credit (HELOC) can help you simplify your debt repayment and even reduce how much you pay in interest. You’ll receive a lump sum payment you can use for a major purchase or for debt consolidation.

However, HELOCs are not without their downsides. They put your home up as collateral, so it’s important to have a full understanding of this approach before signing up. Other options, such as shared equity agreements or mortgage refinancing can be a better alternative for some.

How can I use a home equity loan to consolidate debt?

A home equity line of credit, or HELOC, involves taking a second mortgage against the equity you have in your home. The second mortgage will be separate from your primary mortgage. Because HELOCs work like a mortgage, you use a bank account linked to the credit line to make payments.

For instance, if your home is worth $250,000 and you have $100,000 in equity, then $100,000 is the amount available for a home equity loan. While you may not be able to borrow against the entire amount, it can be useful when paying off other types of debt.

Home equity lines of credit are often marketed as a way to pay for home improvements, but they can be used for whatever purpose you choose. You might have high-interest credit card debt, medical expenses, or personal loans with high interest rates that you want to eliminate. Or you may want to pay off your student loans. Whatever your financial goals may be, a HELOC is secured by your home equity.

This means it comes with a lower interest rate than unsecured debt such as a credit card. Hence, if the home equity loan covers all of your outstanding debt, you can use it to make a single payment rather than making multiple payments.

How to qualify for a home equity loan

If you have built significant equity in your home, you may be able to qualify for a home equity loan. However, lenders may have some basic requirements. Underwriting standards vary, but you may need to meet minimum thresholds for income. Plus, your credit score and credit history should be in good standing.

They may also want your debt-to-income ratio to be below a certain percentage and not allow you to leverage the entire amount of your home equity. Other investments may be considered in determining your eligibility, but each lender is different.

When shopping for a home equity loan is important to compare multiple lenders. We recommend contacting a minimum of three lenders. The comparison tool below is a good place to start if you’re shopping for a home equity loan.

Pros and Cons of a home equity loan

WEIGH THE RISKS AND BENEFITS

Using home equity loans for debt consolidation comes with several pros and cons to consider.

Pros
  • Tax-deductible. Interest paid on home equity loans is tax-deductible, so you may save money on interest payments.
  • Lower interest rates. Perhaps the biggest benefit of using a home equity loan for debt consolidation is the possibility of a lower interest rate. HELOCs typically have a rate of 3% to 5%; compare that to credit cards, which can have variable APRs exceeding 20%.
  • Lower monthly payments. Consolidating debt into a single payment means you may end up with a lower payment. That will allow you to save and invest, or even take a trip you’ve been hoping you could afford one day.
  • Just one monthly payment. Instead of having to keep track of paying five or six different bills, you’ll have just one monthly payment. In addition to saving time, it will be easier to know whether your monthly budget is on track.
Cons
  • Your home is your collateral. Before taking on any loan, you should work the numbers to be sure you can afford the payments. Nevertheless, if for some reason you find yourself unable to make your monthly payments, you face a risk of foreclosure.
  • Added fees. Taking out a second mortgage on your home could result in closing costs, such as origination fees, application fees, and recording fees. That could amount to several thousand dollars, depending on the value of the HELOC.
  • More interest in the long run. Although your interest rate is lower, you could end up paying more in interest in the long run. Credit cards and personal loans have higher interest rates, but they’re often paid off more quickly.

Should you get a home equity line of credit for debt consolidation?

Taking on a home equity loan for debt consolidation be a smart move. You can save thousands of dollars in interest and get out of debt faster. However, it’s important to make sure you are not putting your home at risk.

Even if your finances are rock-solid at the time of signing, things do happen. People lose jobs and life circumstances happen that force them to work and earn less. So, make sure you have a good emergency fund to cover any surprises. Make sure you compare multiple lenders before choosing a loan.

There are scenarios where a home equity loan might make sense. Perhaps you have very high-interest debt, such as a payday loan that is wreaking havoc on your finances. Or maybe you will receive a large inheritance next year that will allow you to quickly pay off the HELOC, and the savings in the meantime will make it worthwhile.

All of this is to say that taking a second mortgage simply to reduce your interest rate by a few percentage points may not be the best decision. Everyone’s situation is different, but it’s important to understand and weigh both the pros and the cons before moving forward with this kind of decision.

Other options

Even if you are adamant about reducing the amount you pay each month in interest, a home equity loan is far from your only option. Consider one of these alternatives that don’t require using your house as collateral.

Use a balance transfer credit card

If you have a small debt to repay, a balance transfer credit card may be a good option. Many come with a 0% introductory APR and may not charge interest for nearly two years. Just keep in mind that after the introductory period, the interest rate will be similar to any other credit card.

Take out a personal loan for debt consolidation

Personal loans can be a good option if you have high-interest debt, such as credit card debt. In many cases, the rate is lower for personal loans, so they may be worth considering. Here is our list of the best personal loans for debt consolidation.

Request a cash-out refinance

A cash-out refinance is similar to a HELOC in that it consolidates your debt into a single payment. It replaces your mortgage with a new loan for more money than what you owed. You receive the difference as a lump-sum cash payment. Here is our list of the best cash-out refinance lenders.

Get a shared equity agreement

Shared equity agreements are a debt-free alternative to home equity loans. They allow you to unlock your home equity without charging interest or monthly payments. They are also easier to qualify for than traditional home equity products, such as home equity loans and HELOCs. See how much you could get today for a share of your home’s future appreciation.

Consider a debt management plan

Credit counseling agencies can work with you to create a debt management plan to fit your finances. They’ll work with lenders so you won’t be over-burdened financially; plus, you will again have just one monthly payment, paid to the credit counseling agency.

Key takeaways

  • Home equity loans usually have lower interest rates than personal loans and credit cards.
  • Sometimes you can deduct the interest you pay on a home equity loan. Other debt consolidation methods, such as credit cards and personal loans, don’t allow for this.
  • Home equity loans use your home as collateral. So, lenders can foreclose on your property if you default on your payments.
  • This is not a great option for borrowers who are struggling financially.

 

Article Sources
  1. Home equity loans and HELOCs – FTC
  2. Home equity lines of credit – CFPB
  3. HELOC frequently asked questions – Office of the Comptroller