One of the most popular uses for home equity loans is consolidating debt – or paying off high-interest loans such as credit cards using the equity loan’s lower rates. A recent MarketWatch Guides survey found it was the second-most common reason Americans take out these loans, after home improvements.
It’s a strategy that can potentially ease financial stress, offering a clearer path to debt reduction and creating an opportunity for improved credit health.
But it’s not without risks: Using a home equity loan or home equity line of credit (HELOC) for debt consolidation puts your home at risk of foreclosure if you can’t make your payments.
In this article, we’ll walk through how you might use a home equity loan or HELOC for debt consolidation and the benefits and drawbacks of this approach.
What Is Debt Consolidation?
Debt consolidation involves combining multiple outstanding debts, such as credit cards, personal loans or other loans, into a single new loan or line of credit. The process simplifies your debt by merging various due dates and amounts into one monthly payment, usually at a lower interest rate. The purpose of debt consolidation is to make repayments more manageable and to help you get debt-free faster.
How Home Equity Loans and HELOCs Work for Debt Consolidation
A home equity loan and a HELOC allow you to borrow against the equity you’ve built in your property. Equity refers to the difference between the current market value of your home and the amount you still owe on your mortgage. These tend to be larger loans, making them ideal for consolidating multiple smaller accounts like credit cards into one.
If you choose a home equity loan, you will receive a lump sum payment that you can use to pay off your other existing debts. After paying off your debts, you then focus on repaying your new fixed loan.
If you choose a HELOC, you have access to a revolving line of credit that you can use as needed to pay off other debts. For example, if you regularly use a credit card, you can access the funds from your HELOC to pay off your credit card balances.
>> Related: Learn more about HELOCs vs. home equity loans
Eligibility for Home Equity Debt Consolidation
Several factors typically determine if you are eligible for home equity debt consolidation:
Credit Score
A healthy credit score not only increases your chances of loan approval, but can also help secure you a more favorable interest rate. Lenders look for a score that demonstrates a history of timely payments and responsible credit management.
Loan-to-Value (LTV) Ratio
Your LTV compares the outstanding balance on your mortgage and the current market value of your home. Lenders use LTV to evaluate the risk associated with the loan. A lower LTV indicates that you have more equity in the property, reducing the lender’s risk. If you have a lower LTV, you are often eligible for larger loan amounts or lines of credit and, possibly, more favorable interest rates.
Debt-to-Income (DTI) Ratio
This ratio calculates your total monthly debt payments as a percentage of your gross monthly earnings. It helps lenders assess your ability to manage monthly payments and repay borrowed amounts.
A lower DTI indicates you have a good balance between debt and income. Lenders often have a maximum allowable DTI to qualify for home equity products, ensuring you are not overextending yourself financially.
>> Related: Read more about home equity loan qualifications
Potential Benefits of Using Home Equity for Debt Consolidation
Tapping into home equity for debt consolidation offers several benefits:
- Lower interest rates: By using home equity, you can potentially secure a lower interest rate than what most credit cards offer. Lower interest rates can save you significant amounts of money over the lifetime of the loan.
- Simplified single payment: Consolidating debts using home equity means you’ll be making just one payment each month, which makes managing your finances easier and minimizes the risk of missed or late payments.
- Fixed repayment structure: A home equity loan offers a fixed repayment structure. With predictable monthly payments, you can benefit from stable budgeting and financial planning.
Risks and Downsides of Home Equity for Debt Consolidation
- Closing costs and fees: Just like your original mortgage, home equity loans and HELOCs come with associated costs. These might include appraisal fees, origination fees and underwriting costs. While some of the best home equity loan lenders offer deals with no or low closing costs, it’s essential to understand and factor in these expenses when calculating the total cost of the loan or line of credit.
- Risk of foreclosure: Using home equity for debt consolidation means your home is collateral. In extreme cases, if you’re unable to meet the repayment terms, lenders have the right to initiate foreclosure proceedings. It’s a serious consideration, as failure to repay your loan can result in the loss of your home.
- A temptation to overspend: With reduced monthly payments, there might be a temptation to see the freed-up income as “extra” money. This can lead to further overspending and accumulating more debt.
- Reducing home ownership stake: Tapping into your home’s equity reduces your ownership stake in the property. This means if the value of your home declines, you could potentially owe more than the home’s worth.
>> Related: Learn more about the pros and cons of debt consolidation
Alternatives to Using Home Equity for Debt Consolidation
If you’re looking for alternatives to using home equity for debt consolidation, there are plenty to choose from.
Balance Transfer Cards
These credit cards often come with promotional periods that offer low or no interest, making them an attractive option for consolidating high-interest credit card debt. By transferring balances from several cards to one, you can potentially pay down the debt faster during the promotional period. However, it’s essential to be mindful of the post-promotional interest rates, which can be steep, and any balance transfer fees. Failing to pay off the balance during the promotional period can result in even higher costs than the original debts.
Personal Loans
These unsecured loans provide a lump sum you can use to pay off other debts. The terms of the unsecured loan are based on your creditworthiness. With fixed interest rates and repayment schedules, personal loans offer predictability but can come with higher interest rates than home equity options, depending on your credit profile.
Debt Management Plans
Facilitated by credit counseling agencies, can also assist you in paying down your debts. These agencies negotiate with creditors to lower interest rates and fees, but they often require the closing of credit accounts, which can impact credit scores.
401(k) Loans
These are more on the more unconventional end, but these loans allow you to take a loan against your retirement savings. While this option provides quick access to cash without affecting your credit score, it does carry the risk of compromising your retirement savings and incurring penalties and taxes if you don’t repay the loan in time.
Cash-Out Refinances
This is where you refinance for more than you owe on your original mortgage and receive the difference in cash. Although this can offer lower interest rates, it often extends the loan term and can lead to paying more interest over time.
Each of these alternatives comes with its own set of advantages and drawbacks. The key is to evaluate each option against your financial situation and consider factors such as the total interest paid, the impact on your credit score and how your long-term financial health may be affected.
The Debt Consolidation Process
There’s a systematic approach to using home equity for debt consolidation. Here’s a step-by-step breakdown of the process:
- Check your home equity and available credit: Begin by determining how much equity you’ve accumulated in your home. This is the difference between your home’s current market value and any outstanding mortgage balance. Most lenders will allow you to borrow up to 80% of your home’s equity, but some will let you borrow up to 90%.
- Check your credit score: Before diving deeper, review your FICO credit score. This will give you a clear idea of your eligibility, as lenders use this to gauge your creditworthiness. Remember, a better score often translates to more favorable loan terms and interest rates.
- Compare loan quotes: Don’t settle for the first offer you come across. Shop around and solicit quotes from multiple lenders. This will allow you to gauge the market and find the most favorable terms tailored to your financial situation.
- Submit your application: Once you’ve settled on a lender, it’s time to submit your application. This typically requires providing personal information, details about your home, proof of income and other relevant financial details.
- Loan approval and closing: After reviewing your application, the lender will decide on approval. If approved, you’ll move forward to the closing process, which might involve additional documentation and closing costs. Once everything is settled, the loan amount will be disbursed, allowing you to use it for debt consolidation.
Each of these steps plays a critical role in obtaining a home equity debt consolidation loan. It’s essential to be thorough, patient and meticulous throughout the process to ensure that you secure the most favorable terms for your financial well-being.
>> Related: How does debt consolidation work?
This is the ratio between how much you still owe on your home and how much it is worth. Generally, you need an LTV of 85% or less to tap into your home equity.
Current loan-to-value (LTV) ratio
This is how much we estimate you can borrow. Lender requirements will vary.
YOU MAY BE ABLE TO BORROW UP TO
Your outstanding mortgage balance exceeds 85% of your home value.
Since most lenders limit the loan-to-value (LTV) ratio for home equity loans at 85%, you may not be eligible for a home equity loan at this time.
Lenders typically require a credit score (FICO) of 620 or higher to qualify for a home equity loan or HELOC.
Lenders typically require a credit score (FICO) of 620 or higher to qualify for a home equity loan or HELOC.
You’ll likely need to improve your credit score before you can tap into your home equity. Check out some tips to do so here.
Is Debt Consolidation Using Home Equity Right for You?
Navigating the decision of whether to use home equity for debt consolidation requires careful consideration and foresight. One of the essential exercises you need to undertake is to calculate the total costs of the loan over its lifetime. While it might be tempting to focus solely on the immediate relief of lower monthly payments, you must factor in the total interest and other associated costs over the entirety of the loan term.
Consulting with a financial advisor is a good move before making any definitive decisions. These professionals can provide an unbiased assessment of your financial health, advise you on the suitability of such a loan and highlight any potential pitfalls. It’s crucial to be cautious about borrowing more than you can realistically afford. Moreover, sacrificing vital financial components like retirement contributions to repay the loan can have long-term repercussions on your future financial stability.
The Bottom Line
Leveraging home equity for debt consolidation can be a strategic maneuver under the right circumstances. If you find yourself grappling with high-interest debts, especially from credit cards, then consolidating these into a single payment with a lower interest rate from home equity can provide financial relief. The streamlined payment process and potential interest savings make this option attractive to many homeowners.
However, before diving headfirst into home equity debt consolidation, it’s crucial to assess the long-term implications. Reducing current spending and ensuring future financial discipline is vital. Remember, your home acts as collateral, so it’s imperative to genuinely assess whether you can afford the new loan repayments.
Overextending yourself can lead to dire consequences, including the risk of foreclosure. It’s always recommended to curtail your spending habits and to evaluate the loan’s affordability. Only then should you consider using your home equity as a means of debt relief.
Frequently Asked Questions About Using Home Equity Loans for Debt Consolidation
What are the pros and cons of consolidating credit card debt into a home equity loan?
Some advantages include lower interest rates, single monthly payments and potential tax-deductible interest payments. Some disadvantages include risking your home to foreclosure if you fail to make your repayments, closing costs and longer repayment periods.
Should you use a home equity loan to pay off credit card debt?
Using a home equity loan to pay off credit card debt can be a prudent financial decision if you have first carefully considered the pros and cons. If you can secure a low interest rate and responsibly manage your home equity loan repayments, a home equity loan can help you save money.
Is it smart to use equity to pay off high-interest debt?
Using equity to pay off high-interest debt can be a smart move given the potential for significant savings on interest payments. However, it’s crucial to assess your financial situation, understand the terms of the equity loan and ensure you don’t risk losing your home by failing to make repayments.
What credit score do you need to qualify for a home equity loan or HELOC?
While requirements can vary by lender, generally, a credit score in the mid-600s or higher is favorable for home equity products. Some lenders may approve you with a lower score, but this might come with higher interest rates or stricter loan terms.
How does debt consolidation affect your credit score?
Initially, applying for a new loan can cause a small, temporary dip due to the hard inquiry on your credit report. However, if managed well, consolidating debt can improve your credit score over time by reducing credit utilization and diversifying your types of credit. It’s crucial to maintain timely payments to reap the potential benefits to your credit score.
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someone you trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
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