Homeowners have the unique opportunity to borrow against their homes to pay off other debts, such as car loans, credit cards and student loans. Debt consolidation doesn't only simplify your monthly payments, but it also has the potential to significantly reduce your long-term interest expense when using cheap home equity financing. To determine whether this is a good idea for you, consider the long-term and short-term benefits of debt consolidation using home equity versus its costs.
- Pros and Cons of Using Home Equity for Debt Consolidation
- How to Consolidate Debt Using Home Equity
- Is It Better to Consolidate Debt With a Home Equity Loan or HELOC?
- Other Options for Debt Consolidation
Pros and Cons of Using Home Equity for Debt Consolidation
If you’re thinking about consolidating your debts, a home equity line of credit (HELOC) or home equity loan may be worth considering. The interest rates on home equity loans and lines of credit are often much lower than credit cards and other installment loans, so transferring your debt to a low interest rate home equity loan can save you a lot of money in the long run.
Home equity loans are generally closed-ended loans, consisting of a single disbursement of funds at initiation and are paid off over the loan term with fixed monthly payments.
HELOCs are revolving lines of credit, where multiple draws can be made over time, up to the maximum loan amount. Borrowers can continue to use their credit line until the end of the draw period, where they are no longer permitted to borrow against the line, and must pay off their remaining loan balance over the stated repayment period.
Home equity loans and lines of credit aren’t without risk; if you fail to make your monthly payments, the lender could foreclose on your home—even if your primary mortgage is current. It’s also possible that your home could decrease in value, leaving you owing more than the home is worth. When home values fell sharply in the late 2000s, many HELOCs were even suspended by lenders for collateral depreciation, and no more draws were permitted.
Pros and Cons of Home Equity Financing:
When you use home equity to pay off higher interest debts, like credit cards, it’s important to understand that you are collateralizing or backing this new loan with your home. Failing to make payments and defaulting on a home equity loan could result in the loss of the home to foreclosure. In the event that your home value declines, you could end up owing more than your home is worth.
Credit cards and personal loans are considered unsecured debt, because they aren’t tied to real property (like a home or a car). As a result, these types of debt could be discharged through bankruptcy proceedings if you have no other options. Home equity loans and HELOCs are both considered second mortgages (or junior liens) and are subject to the same rules for short sale, foreclosure and deed-in-lieu as primary mortgages.
How to Consolidate Debt Using Home Equity
When applying for a home equity loan or line of credit, lenders are going to consider both your ability to repay the loan and the value of your home when determining how much you can borrow. In order to qualify, you may need to indicate which debts you intend to pay off with your new loan. This will factor into your new debt-to-income ratio.
You’ll need to provide supporting documentation, such as pay stubs, tax forms and current mortgage statements as part of the loan process to validate your income and assets. Lenders will also request a copy of your credit report to verify that your credit history is acceptable under their criteria. Most lenders have minimum credit score requirements, but some are more forgiving than others.
Most lenders aren't willing to lend more than $250,000, but each lender sets their own threshold. Additionally, most home equity lenders won’t lend above a combined 80% loan to value—meaning that you’ll need to keep at least a 20% equity stake in your home between your first mortgage and your new home equity loan.
Is It Better to Consolidate Debt With a Home Equity Loan or HELOC?
When consolidating other debts, it makes sense to receive a single lump sum and begin the repayment period if your goal is to become debt-free. Home equity loans lock in a low fixed rate from the onset of the loan and establish a definitive date at which you will become debt free.
Using a HELOC to consolidate debts gives you more flexibility to consolidate additional debts over time and could be useful if you intend to use part of the credit line to complete home improvements or plan for future expenses requiring multiple draws. However, they may encourage poor borrowing habits by allowing you to take out more debt at lower rates, so it’s best to monitor your usage when employing a HELOC for debt consolidation.
Home Equity Loans vs. HELOCs
|Home Equity Loans||Home Equity Lines of Credit|
|Interest Rates||Lower rates than most credit cards and installment debts.||Lower initial rates than home equity loans with variable rates that change over time.|
|Fees & Closing Costs||2% to 5% of the loan amount.||2% to 5% of the credit line.|
|Fixed vs. Variable Rates||Fixed Rate.||Variable Rate.|
|Loan Term||Usually 5 to 15 years.||Typically 15, 20 or 30 years, consisting of 10-year draw and remaining repayment period.|
|Flexibility||None, one lump sum paid upfront.||Draw period allows for multiple disbursements as needed.|
|Repayment||Fixed monthly repayments begin immediately after funds disbursed.||Repayment often not required until end of draw period.|
Consider this example: If you consolidate $50,000 in other debts into a home equity loan at a rate of 6% and repay the loan over 30 years, you’ll pay a set amount in interest over the life of the loan ($59,919.09 in this case). It could save you a significant amount of money over making minimum payments on your credit cards at average rates of 15% to 20%.
If you use a HELOC instead, with a 10-year interest-only period and a 20-year repayment, you could reduce your monthly payments in the short term and have the flexibility to draw only as much as you need over time.
Other Options for Debt Consolidation
If you decide that a home equity loan or line of credit isn’t right for you, there are several other options for debt consolidation you may consider:
These short-term loans allow you to consolidate debt without tying up the equity in your home. With terms ranging from three to five years on average, the loan payments could be higher than your current minimum payments.
The interest rates on these loans are often higher than home equity loans, and loan limits usually fall under $50,000, but these could be a good option if you don’t own a home or need cash fast. When comparing these against home equity loans, it boils down to total cost and how quickly you need the funds.
These mortgage loans achieve the dual purpose of refinancing your existing mortgage and cashing out equity simultaneously. By reworking your current mortgage into a higher loan amount, you can use the remaining cash proceeds to repay your other debts.
You could refinance into a lower interest rate and pay much less interest than home equity loan products, personal loans and credit cards would charge. Keep in mind that the cash-out refinance process will require fees and closing costs. Borrowers will also need to qualify for the new larger loan amount. However if the interest rate on your outstanding mortgage is beneath what you can obtain through a cash-out refinance, you’re likely better off considering other options.
Debt Relief Programs
Programs like these are often not about consolidating debts but instead focus on negotiating reduced repayment plans with your creditors. Despite the benefits of partial payments, these are likely to harm your credit score in exchange for “debt relief.” As the creditors will mark your accounts as “settled for less than the amount due.”
Generally, these are programs should be seen as an option of last resort to try to avoid filing for bankruptcy protection. If you still retain a decent credit score and own a lot of equity in your home, it may be better to consolidates your payments under a long-term home equity loan or cash-out refinance.