If you feel like you’re struggling with debt, you’re not alone.
The average amount of non-mortgage household debt in the U.S. reached $25,104 in 2018, according to Experian’s State of Credit Report. The good news is that home equity interest rates are still near historic lows. Assuming you have enough equity in your home, this avenue of debt consolidation could be a better and cheaper alternative to carrying high-interest debt.
Homeowners can borrow against the equity they’ve accrued in their property, often at a lower interest rate than other types of debt. The funds can be used to pay off credit cards, auto loans or other debts while saving money on interest.
“It’s generally a good option to pay down credit card debts or personal loans, assuming it’s done responsibly,” says Andrew Weinberg, principal at Silver Fin Capital Mortgage in Great Neck, New York. “It can save a lot of money.”
There are two ways to access home equity – a home equity loan or a home equity line of credit, or HELOC. A home equity loan offers a one-time lump sum payment of funds taken as a second mortgage on your home. A home equity line of credit is a revolving line of credit that enables you to withdraw money over time as you need it and pay back the loan in monthly installments, retaining access to reuse the available credit.
Your home’s equity is its current value minus the loan balance you still owe. Tapping too much of your equity is risky, and you could wind up underwater in your mortgage if market conditions turn. This means you might owe more on the house than it’s worth, making it difficult for you to move without putting up cash to make up the difference.
“The value of a house goes up and can go down. As a general rule, I would never recommend anyone borrow more than 80 percent of their home’s value,” says Mike Zovistoski, managing director at UHY Advisors.
Advantages of using home equity to consolidate debt
Whether you use a home equity loan or HELOC, tapping your home equity to consolidate debt can offer several advantages:
You’ll have just one payment
If you’re juggling car loans, a personal loan, medical bills and credit card debt, you already know how challenging it can be to keep track of due dates. By consolidating your debt, you may be able to combine it all to one single payment per month, simplifying your bills and reducing the chance of missed payments.
You’ll know when your debt will be paid off
Assuming you don’t keep using your cards, using a home equity loan or HELOC to consolidate debt streamlines the process of paying those accounts off. With a home equity loan product, you’ll have set repayment terms and know the exact date when the loan will be repaid.
You can get a lower interest rate
Because the debt is secured against your property, home equity loans and HELOCs have significantly lower interest rates than credit cards. The average variable credit card interest rate was 17.47 percent as of mid-November 2019, according to Bankrate data. Meanwhile, the average rate of a home equity loan was 5.77 percent and 6.04 percent on a $30,000 HELOC.
A home equity loan also enables you to lock in an interest rate, unlike a credit card that can increase at any time. Additionally, with a home equity loan, more of your monthly payment goes toward the principal rather than the interest.
“It’s almost always going to be a better deal than the rates you’ll pay on credit cards,” Weinberg says of home equity products.
You can save on interest
The ability to lock in a lower rate not only saves money in the long term, but can also equate to a lower monthly payment and help you pay down the debt faster.
For example, if you had $10,000 in credit card debt at a 16 percent interest rate, you’d pay $243 per month and more than $4,591 in interest by the time you pay it off. Consolidating that debt with a five-year home equity loan would not only allow you to pay off the debt faster, but also reduce your monthly payments to $193 and save $3,391 in interest.
“If the borrower is able to continue making the same monthly payment amounts that were originally scheduled on the high-cost debt, they would be able to repay the debt over a shorter period of time and save money,” Zovistoski says.
Disadvantages of using home equity to consolidate debt
While a home equity loan or HELOC can be a good way to consolidate and better manage debt, it comes with risks and downsides:
It takes time
Unlike opening a credit card or filling out an application for a personal loan, applying for a home equity loan or HELOC is a more in-depth process. The bank will typically want an appraisal of your home along with two years of tax returns, W-2s and bank statements. It can typically take up to 30 days or more to close on a home equity loan or HELOC and get access to the money.
Your house is the collateral
HELOCs and home equity loans are forms of secured debt that use your home as collateral. This enables lenders to offer much lower interest rates and more favorable terms than credit card companies, but it presents a greater risk: losing your home if you fail to repay the loan.
While credit card companies and personal lenders can’t come after your home, a bank could foreclose if you default on a HELOC or home equity loan. In other words, don’t take out a HELOC or home equity loan unless you can comfortably afford the payments, in addition to your normal monthly mortgage payment, Zovistoski says.
Lender fees and closing costs
Depending on the lender you choose, you’ll face some charges such as closing costs and appraisal fees, all of which can add to the cost of the loan. When shopping for a lender, make sure you understand the closing costs that each lender charges and how it will affect overall borrowing costs. Some may claim to offer no fees, then assess penalties if you close the account before the term ends, Weinberg says.
You may fall back into debt
One of the greatest risks is that you may use home equity to pay off your credit card debts only to run those same cards up again. People who have a history of debt problems can be susceptible to falling into that trap again. It’s not an uncommon scenario, Weinberg says.
“They may come back in a couple of years and be back where they were with more credit card debt,” Weinberg says. “You can only do it so many times before you run out of equity.”
Tax deductibility is restricted
Under previous tax laws you could deduct the interest you paid on a home equity loan or HELOC, regardless of its use. The new tax law now restricts the mortgage interest deduction on home equity loans or HELOCs to use the money to buy, build or renovate the home you’re borrowing against. Even so, the significant savings in interest rates on home equity products compared with credit card rates still make home equity borrowing a worthwhile option.
Alternative ways to consolidate debt
Home equity loans and HELOCs aren’t your only options for tackling debt. Here are more alternatives for debt consolidation that don’t involve borrowing against a property that you own.
Balance-transfer credit cards
If you have high-interest credit card debt, you may be able to save money on interest with a balance transfer credit card. Banks often offer introductory rates as low as 0 percent for six to 12 months or longer. Some cards allow you to transfer outstanding balances from two or more credit cards to the balance-transfer card. This can provide a breather from your current cards’ high APRs and give you time to work on paying down the amounts.
If you’re able to get a balance transfer credit card with zero-interest period, it’s best to transfer only an amount that you are sure to be able to pay off before the introductory period expires, when a much higher APR will kick in.
Low-interest debt consolidation loans
Debt consolidation loans are a type of personal loan in which the lender issues a lump sum that you use to pay off your debts. Instead of having to make multiple payments each month to various creditors, you can then make a single monthly payment to the debt consolidation lender. Depending on your credit, you may be eligible for a loan with an interest rate that is substantially lower than typical credit card rates. You’ll still have debt, but it could be less expensive and easier to manage.
Unsecured personal loans typically come with fixed interest rates that may be considerably lower than typical credit card APRs. You can apply for a loan from a bank, credit union or online lender and use the money to pay off higher-rate debts.
With decent credit, the amount you save on borrowing costs can be significant. Many people find it easier to manage just one monthly payment instead of paying multiple credit card bills. However, if your income isn’t high enough compared to your debt, you may not qualify for an affordable personal loan.
Debt relief programs
If your credit isn’t good, or your debt is high relative to your income, debt consolidation might not be the best option. You might want to explore debt relief programs instead.
Debt management plans
One avenue is to work with a certified, non-profit credit counseling agency on a debt management plan. It won’t hurt your credit score but will require you to close all your accounts included in the plan. You’ll have to make monthly payments to the agency, which in turn then makes the payments to your creditors. If you have debts with multiple credit cards or lenders, you’ll be saved the hassle of tracking multiple bills and due dates.
Debt settlement plans
Another option is a debt settlement plan. While you’ll be able to reduce the balance by agreeing to settle with one or more creditors for less than what you owe, your credit score will suffer significantly. You’ll also have to pay fees and income taxes on the amount forgiven, a consideration that could make debt management less attractive.
The bottom line
It’s a smart idea to shop around with several different home equity lenders to ensure you get the best rates and terms. Having a plan for how you’ll attack high-interest debt — and how you’ll repay your home equity loan or HELOC — can set up your finances for a more secure future.
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