How you decide to pay off debt is unique to you; not every method works for every person. Some people tackle their debt through the debt avalanche or debt snowball methods, while others work on debt consolidation.
If you own your home, you may want to consider using your home equity for debt consolidation. A home equity loan could be a good tool to get a handle on your mounting debt.
What is a home equity loan?
Equity is the value of your home minus what you currently owe on it. Homeowners can use their home equity to help pay off debt through either a home equity loan or a HELOC. A home equity loan is a lump-sum loan used as a second mortgage against your home. Home equity loans sometimes come with a lower interest rate than other types of debt consolidation. You’ll pay it back through monthly installments until the loan is paid in full.
Another option is a home equity line of credit, or HELOC. A HELOC is a revolving line of credit that lets you borrow money using your home’s equity. Instead of a lump-sum payment, you’ll withdraw money when you need it. A HELOC is like a credit card, in that you only take out what you need when you need it then repay it over time.
How to choose between a home equity loan and HELOC
Before you tap into your home’s equity to pay off debt, try exploring other options first. Because you’re using your home as collateral, home equity loans and HELOCs are considered secured loans (or credit lines). This means that if you don’t stay current on your payments, you could face a lien on your home.
Secured loans usually carry a much lower interest rate than other types of loans, like personal loans, which is part of why they’re an attractive option for debt consolidation.
For debt consolidation, a home equity loan is usually a better option than a HELOC. You’re able to take one lump sum to pay off all your debt, then make one monthly payment to your home equity loan.
But the type of debt you have also determines the best option for you. For instance, if you expect to have a lot of medical debt in the future but don’t know how much it’ll be, a HELOC can help you cover expenses when they arise.
Using a home equity loan for debt consolidation: pros and cons
While a home equity loan might work for some people, it’s not necessarily the best choice for everyone. Before you take out a home equity loan to pay off debt, make sure you review the pros and cons.
- One streamlined payment: Rather than many payments to worry about throughout the month, you’ll have one easy payment.
- Lower interest rate: Since home equity loans are secured loans, you’ll likely be able to get a lower interest rate than with other types of loans. It may also be lower than the interest you pay on your other debt, like credit cards.
- Make lower monthly payments: With a lower interest rate and only one loan to worry about, your total loan payment might be less than all your other debt payments combined.
- Your home is collateral: The way to a lower interest rate is through your home. Because your home is used to secure the loan, on-time monthly payments are crucial. If you miss payments or fall behind, you could face foreclosure. If you can’t make payments, you may want to find other ways to consolidate debt.
- Increased debt load: While a home equity loan can consolidate your debt, it’s only helpful if you limit the spending that caused that debt to pile up in the first place. For instance, if you have a mountain of credit card debt, pay it off and then continue to rack up more credit card debt, you’re making your debt worse. Now you’ll owe a home equity loan payment as well as credit card payments.
- Possible fees and charges: Since a home equity loan uses your home’s current value, you may need to pay for a new appraisal of your home. Because a home equity loan is considered a second mortgage, you might be on the hook for closing costs as well.
Other ways to consolidate debt
While a home equity loan is an option for debt consolidation, it’s not the only choice you have. Before choosing it, make sure it’s the right one for you by comparing all your options.
- Personal loans: Even though personal loans carry a higher interest rate than home equity loans, they don’t carry the weight of your home with it. In case an emergency comes up and you can’t make payments, you won’t lose your home through a personal loan.
- Balance transfer credit cards: If the majority of your debt is through credit cards, you can transfer your balances to a 0 percent APR credit card. These offers are typically temporary, but they might give you enough time to move your balances over and pay them off without the extra interest costs. Keep in mind that not all cards will approve your full balance; if you have lots of debt, you may still have to pay off some of your old cards with interest.
- Debt management plans: Nonprofit credit counseling agencies can work with you to create a plan that’s best for your finances. You’ll make one monthly payment to the counseling agency and then it’ll pay off your debt for you. It will negotiate your rate and payment with lenders so you can get on a plan that won’t put you in a financial bind.
The bottom line
Getting a home equity loan to pay off debt may work for some people, but if you don’t want to put your home on the line, explore other options first. You might find that personal loans or credit card balance transfer options work better.
But if a home equity loan is your best option, compare lenders, offers, rates and terms. If you can’t get better terms or a lower interest rate than what you currently have, keep looking at what other lenders offer. 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.