Pros and Cons of Debt Consolidation Using Home Equity
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Tapping into your home equity to consolidate your debt is an important financial decision. Borrowing from your home equity to consolidate your debt to one monthly payment at a lower interest rate may seem like a win-win situation. But, there are serious disadvantages too. If you run into trouble making the monthly payments on your home equity loan, you risk losing your home. So, before taking this step, review the pros and cons of a home equity loan to see if this is the best option for you.
Written by Attorney Kimberly Berson.
Updated October 8, 2021
Tapping into your home equity to consolidate your debt is an important financial decision. If you have a lot of debt, you may be struggling to find ways to pay it off. Having to pay a lot of bills every month can be distressing. So, borrowing from your home equity to consolidate your debt to one monthly payment at a lower interest rate may seem like a win-win situation.
Yes, there are advantages to taking out a home equity loan to pay off your credit card debt and any other debt. But, there are serious disadvantages too. If you run into trouble making the monthly payments on your home equity loan, you risk losing your home. So, before taking this step, review the pros and cons of a home equity loan to see if this is the best option for you.
How should you use home equity?
Having equity in your home is a great thing. It provides you with security in case of an emergency. So, when you use it, make sure it benefits you in the long run. You don’t want to end up in a worse situation down the road. Before discussing the pros and cons of a home equity loan, let’s go over what home equity is.
Home equity is the part of your home that you own free and clear of any mortgages or liens. The equity in your home is the difference between what the home is worth minus the mortgage and liens. For example, if the market value of your home is $400,000 and you still owe $250,000 on the mortgage, your home equity is $150,000.
You can build up equity in your home. Each time you make a mortgage payment you build equity. For example, if you bought your home for its market value of $300,000 and borrowed $300,000, you would have no equity in the real estate to start. After making your monthly payments for seven years, say you’ve paid down the loan principal by $50,000. This means you gained $50,000 in equity.
Also, if your home value increases, your equity in the home increases. In the same scenario, if the home value increased by 20% to $360,000, the equity in the home would increase to $110,000. That’s the $50,000 you paid on the home plus the $60,000 increase in home value.
Home equity is one of the best ways homeowners can grow personal wealth. Homeowners build up equity by paying their monthly mortgage payments. Real estate typically increases in value over time, too. If this is the case, when you go to sell your home, you will earn a profit. Increasing the equity in your home will be a financial benefit in the future.
Should you use your home’s equity as a debt management tool?
You must be feeling overwhelmed if you’re contemplating taking out a home equity loan to consolidate your debts. Consolidating your debts into one home equity loan does not get rid of the debt. You are borrowing against the equity in your house to pay off debt, and you are acquiring a new loan. Although the payments on the new loan may be more manageable, the new debt is riskier.
When you consolidate debt in a home equity loan, you are converting the debt from unsecured debt to secured debt. Credit cards, medical bills, student loans, and personal loans are usually unsecured. Unsecured debt isn’t tied to any property. If you don’t pay, the creditor can’t take your property unless they get a court order. Secured debt is debt that is attached to a specific property. If you don’t pay, the creditor can sell that property. A mortgage is a secured debt. If you don’t make your monthly payments to the lender, they can sell the home.
Many homeowners might think it is a great idea to use the money from a home equity loan to pay off their credit cards, student loans, and other debt. Rather than having to make several different monthly payments, they only have to make one. Also, home equity loans usually have lower interest rates than credit card debt. But before you consolidate your debt into a home equity loan, make sure you can afford the payments.
If you default in making the monthly payments, you risk losing your home. A home equity loan is a mortgage on your home. If you have a mortgage, it will be a second mortgage. If you default in making mortgage payments, the lender will have the right to start foreclosure proceedings against you. In a foreclosure action, the lender is trying to get a court order to sell your home. It’s much worse to lose your home than it is to have a low credit score because you can’t pay your credit card bills.
Some borrowers who are considering home equity loans to pay off debt have spending issues. In this case, consolidating credit card bills may help them manage debt, but it won’t address their spending behaviors. A credit counselor can help folks examine their spending patterns. Understanding why you made certain financial decisions can help you make better ones in the future.
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Home equity loan or HELOC?
Home equity loans and home equity lines of credit (HELOC) are two of the most common ways to borrow money using the equity in your home.
Home Equity Loan
A home equity loan is also known as a second mortgage. You borrow a specific amount of money, and at the closing, you get a lump sum cash payout. Repayment of the loan will begin immediately. Home equity loans have fixed interest rates and are for fixed terms. So, the monthly payment will remain the same every month for the loan term. The amount you can borrow will depend on the equity in your home.
Lenders will consider several factors to determine whether to give you the loan and how much to loan you. They will look at your credit score and annual income and the loan-to-value ratio. The combined loan amount can’t be more than 80% to 90% of the home value. For example, if your home value is $300,000 and the amount due on the first mortgage is $200,000, the home equity loan can’t be more than $40,000 to $70,000.
Home Equity Line of Credit
A home equity line of credit (HELOC) is like a credit card. You are granted a line of credit for a specific time frame. You can borrow money when you need it and make interest payments only during a period called the draw period. When this period ends, you can’t draw out any more funds. Draw periods last 5-10 years. You being repaying the loan after the draw period ends. The repayment period is 10-20 years. If it is a 30 year HELOC, the draw period will be for the first 10 years, and the repayment period will be for the remaining 20 years.
The loan amount you get approved for will depend on how much equity you have in your home. Once you are approved, you can draw on the money, pay the loan down, and draw again. HELOCs typically have variable interest rates, so the monthly payment can change. Some lenders may offer fixed-rate HELOCs.
Some borrowers choose a cash-out refinance instead of a home equity loan or a HELOC. In a cash-out refinance, borrowers take out a new loan. They use the money to pay off the old mortgage and receive a cash payout. The interest rate may be higher because it is a higher loan. Like home equity loans, the maximum cash-out is between 80%-90% of the equity in the home. Refinancing also puts your home at risk if you can’t make the payments.
Advantages Of Using Home Equity to Pay Debt
A home equity loan is one way to manage your debt, but you need to be disciplined to use it. You have to be able to make the monthly payments. One major advantage of a home equity loan is the interest rate. It’s lower than the high interest rate on credit cards. So, it might save you money to pay off higher-interest debt with a home equity loan.
Home equity loans and HELOCs usually have significantly lower interest rates than other kinds of loans. Home equity loans are fixed-rate loans, and the monthly payments don’t change, so it’s easier to budget. With HELOCs you can borrow as much or as little as you need. The less you draw on it, the lower your monthly payment will be.
Home equity loans and HELOCs are good options for funding home improvements. Interest on the home equity loans and HELOCs are tax-deductible if you use the money to make home improvements. You could also use a HELOC to help pay college tuition. The interest rates are typically lower than student loans. In general, home equity loans are better for longer-term expenses.
Home equity loans are also beneficial if you need emergency cash. If you lose your job and need money or have a medical emergency, a home equity loan or HELOC may be your best choice. Some borrowers use home equity loans or a HELOC to invest in the stock market. Smart investments can increase wealth, and you can use investment income to pay back the loan. But this is also risky.
Some people use the equity in their house to pay for a wedding because home equity loans have lower interest rates than personal loans. Since weddings are typically expensive, couples can save money by taking out a loan with a lower interest rate. You could also use a home equity loan to help expand an existing business. Your business needs money to grow, and the interest rate on a home equity loan will probably be lower than the interest rate on a business loan. So, a home equity loan may be a better choice than a business loan.
Tapping into your home equity to pay for an extravagant vacation isn’t a good idea. Using home equity to buy a fancy car instead of taking a car loan isn’t a wise choice. The risk of losing your home if you can’t make the car payments is worse than losing your car.
Disadvantages of Home Equity Cash-Out for Debt Payment
HELOCs’ variable interest rates are risky. Borrowers may struggle to make monthly payments that change. If interest rates rise, the monthly payment can go up significantly. With the HELOC, you are only making interest payments during the draw period. When you enter the repayment period, the principal and interest payments may be a lot higher. Prepare for this increase.
Home equity loans and HELOCs may have lower interest rates, but they have to be worth the risk. You are converting unsecured debt into secured debt, and if you can’t make the payments on these loans, you can lose your home in foreclosure. A foreclosure occurs when the lender starts a lawsuit against you and seeks a court order to sell your home. You would need to respond to the legal action. If you don’t, you will probably lose your home.
Paying off your debts with a home equity loan doesn’t make you debt-free. It lumps all your bills in one to create one big expense. Getting a home equity loan may be difficult, and lenders will check your credit history. You’ll need a credit score of at least 620 to qualify. Also, when you close on the loan, you will incur closing costs and origination fees. These additional expenses might reduce the amount of cash you receive at closing.
Alternatives to Home Equity Loans When Dealing With Debt
You can consolidate your debt without putting your home on the line. A debt management plan will consolidate your debts into one monthly payment and may help you reduce your interest rates. The good news is the debt stays unsecured, so you won’t risk losing your home or property. It doesn’t become secured like a home equity loan. A debt counseling agency will probably be able to help you with a debt management plan.
You may also want to consider a balance transfer credit card. You can transfer the balance on one credit card to another that has a lower interest rate. Some balance transfer cards offer attractive introductory offers. The interest rate can be as low as 0% for several months after you open the account. Then the interest rate will go up.
Bankruptcy can be a great tool to help you eliminate unsecured debt. Many folks who file Chapter 7 bankruptcy are able to keep their homes. Federal and state laws allow you to exempt a certain amount of equity in your home. So, many people who file chapter 7 keep their house even if they have equity.
Chapter 13 bankruptcy is a repayment plan. Many times, Chapter 13 filers pay only a portion of what they owe to their unsecured creditors. You can keep your home in Chapter 13. Talking to a lawyer about whether bankruptcy is right for you can be helpful.
If you are struggling to pay your credit cards and other bills, consolidating them into one payment can be beneficial. Home equity loans and HELOCs have lower interest rates than other types of loans and allow you to pay the loan over an extended time. But they are secured, so you are putting your home on the line. If you can’t make the monthly payments, you risk losing your house through foreclosure.
A home equity loan may help you manage your debt, but it won’t wipe out your debt. It gives you one bigger loan to repay. Taking out this type of loan is a big financial decision. Go over your budget and seriously consider your options before deciding what’s right for you.