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- A home equity loan can be a good option to consolidate debt, as it usually carries lower interest rates and longer terms than other financing options.
- Advantages of using home equity loans or HELOCs to pay off debts including the streamlining of payments and lower monthly payments (compared to credit card bills, especially).
- Putting up your home as collateral and diluting your ownership stake are disadvantages of home equity loans.
If you’ve been watching the size of your credit card debt grow recently, you’re not alone. Almost half of all cardholders carry a balance from month to month with about 54 million adults having been in debt for a year or more, according to a recent Bankrate survey. That’s especially tough news since credit card APRs — like interest rates in general — have been steadily rising, due to the Federal Reserve’s continued efforts to tame inflation.
Credit cards are only one part of the American debt story, too: 70 percent of consumers are in hock in some way, from auto loans to medical bills, and 92 percent of them are actively looking for ways to shed their debt, according to survey data from CreditCards.com, Bankrate’s sister site.
If you’re a homeowner, a home equity loan can be an effective means to consolidate it all under one roof. The average interest rate on home equity loans — and HELOCs, their line-of-credit cousins — is often much lower than the rate attached to credit cards and personal loans.
This sort of financing isn’t without risk, though. You’ll increase your monthly debt load, and your home could be foreclosed if you fall behind on payments. Here’s the info you need to decide if a home equity loan is the best way to consolidate your debt.
Using a home equity loan to pay off debt
- Home equity loan
- A home equity loan is a second mortgage that comes with a separate set of terms and its own fixed interest rate. You receive a lump sum that you repay in installments, the same amount each month.
- Home equity line of credit
- A home equity line of credit (HELOC) works like a credit card — you have access to a credit line that you can draw from and pay back as needed during a certain time period. It carries a variable interest rate, so your payments fluctuate.
Because they have lower interest rates than other loans, using a home equity loan to pay off debt is a viable choice for homeowners.
“Even in a rising rate environment, home equity loans can be a good option for debt consolidation because they remain a less expensive option than unsecured loans,” Laura Sterling, vice-president of marketing for Georgia’s Own Credit Union, says. “If a consumer has a significant amount of equity in their home, has the discipline to stay within their means when it comes to borrowing, and has sound financial health, it can be a cost-effective way to pay down debt.”
However, she adds, “it takes discipline and comes with risk.”
Using home equity to consolidate debt is not the right choice for everyone, especially if you aren’t responsible with debt management or repayment. If you’re late repaying your home equity loan (or, worse, miss the payments altogether), you could put your home at risk of foreclosure.
Pros of using home equity to consolidate debt
Using your home equity for debt consolidation can be a smart move for a number of reasons.
One streamlined payment
When you consolidate your debt by using your home equity, you can simplify your life. Rather than paying one credit card bill on the 15th, another on the 20th and your personal loan on the 27th, you’ll just have one due date to remember every month. Since on-time payments are a critical component of your credit score, this can help eliminate the potential for missing a payment due to calendar confusion.
Lower interest rate
A home equity loan generally comes with a lower interest rate than other types of loans since your home serves as collateral for the loan. If you have outstanding debt on a credit card, a personal loan, student loans or other debts, consolidating with a home equity loan could make it cheaper to pay them off. Plus, a home equity loan is a fixed rate, so your payment will always be the same. That’s a big difference from a credit card, which has a variable APR. (Note: Most home equity lines of credit (HELOCs) also have fluctuating rates, though you can sometimes switch to a fixed-rate HELOC. It makes a HELOC for debt consolidation worth a second thought.)
Lower monthly payments
Using a home equity loan for debt consolidation will generally lower your monthly payments since you’ll likely have a lower interest rate and a longer loan term. If you have a tight monthly budget, the money you save each month could be exactly what you need to get out of debt.
Cons of using home equity to consolidate debt
While a home equity loan for debt consolidation might work for some people, it’s not necessarily the best choice for everyone.
Secured by the home
“Because the borrower’s home is used as collateral, borrowers need to be cautious,” Sterling says. “Otherwise, they risk losing their home.” The potential for foreclosure should be top of mind if you’re thinking about applying for a home equity loan. Should you sell your home while the loan is outstanding, you’ll have to repay it all at once, the same way you’d have to settle your original mortgage.
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. Not to get psychological, but it’s crucial to address the root cause of your debt before taking on another loan.
Borrowers need to have a healthy amount of home equity (owning at least 20 percent of the home, and preferably closer to 40 or 50 percent), to qualify for these loans. But bear in mind that, by borrowing against your home equity, you’re essentially depleting your ownership stake. In other words, your assets have shrunk, and your obligations have increased. That’s not going to improve your debt-to-income ratio or your loan-to-value ratio, two aspects of your financial profile that lenders often look at.
You might be on the hook for closing costs — various little extra expenses imposed by the lender: an origination fee, a home appraisal fee (to verify your home’s value), a credit report fee — to name just a few. These expenses tend to be less than those for mortgages, but they do add up. If you have a lot of debt to consolidate, paying these extra fees might still make sense, but it’s wise to budget for them, and compare them to the amount you’d ultimately save in interest with the loan over the credit card bills.
What kind of debt should you consolidate using a home equity loan?
These are the types of debts that are well-suited to being paid off with home equity loans.
Many homeowners use a home equity loan to settle outstanding credit card balances — after home renovations, it’s the most common application. The reason is simple: home equity loan interest rates (currently around 9 percent) run at least half of those of credit cards (over 20 percent). That means you can pay your credit cards off with one lump sum, faster and more cheaply, than you would by just making the minimum credit card payment each month.
Personal loans vary a great deal, but odds are the interest rate on yours will be higher than that of a home equity loan, especially if it’s unsecured. Loans that aren’t backed by any collateral usually are pricier than secured ones, because the lender is assuming more risk. Home equity loans often offer much longer repayment terms — as much as 20 years — than personal loans do, too.
Medical expenses can arise unexpectedly and add up very quickly, especially if hospitalization is involved. You can use your home equity to cover such healthcare costs, if a substantial amount isn’t covered by health insurance. And if you opt for a HELOC, you can benefit from flexible repayment amounts (most allow for interest-only payments during their initial draw periods).
Student loans/Educational bills
If you need to pay off student loans, borrowing money from your home is one possible way to do it — provided the home equity loan offers a lower interest rate or other more favorable terms. However, you won’t get to take advantage of the student loan tax deduction, and if it’s a federal loan, you’ll lose other potential benefits, like forgiveness or income-based repayment options. A better course might be to pay college tuition directly with a HELOC, which allows you to withdraw funds in installments, owing interest only on what you borrow.
Bankrate’s take: Whatever your type of debt, always be sure to compare several home equity lenders' offerings. Shop around not only for the best interest rate/APR, but the smallest fees and closing costs.
What kind of debt should you not consolidate using a home equity loan?
There are some times when a home equity loan may not be the best idea.
A car is an item that depreciates, meaning that it loses value over time. That means in a few years, your home equity loan balance could be more than the value of your car. Also, auto loan rates are currently competitive with home equity loans.
Though tempting, it is not a good idea to use a home equity loan for a vacation or other discretionary items. If you have to take a loan, it means that your income cannot sustain your spending and this bad habit can sink you lower into debt. Before you splurge, remember how long a loan will last; you will be still repaying it long after the good times are over.
Since mortgage rates generally run lower than home equity rates, it rarely makes sense to pay off your primary mortgage with an HE loan or HELOC. In some cases, you might consider refinancing instead (see cash-out refinance in “Other ways to consolidate debt,” below).
Investing is important, but going into debt to do so is a debatable move — especially given the current high cost of borrowing, which rivals any stock market returns (it was arguably a good strategy a few years ago, when loan interest rates were at historic lows). And a crash in stock prices can erase the home equity you have spent years building up. Avoid using a home equity loan for investments: Better to use savings or earned income, especially if you can invest via a company 401(k) plan.
The decision to choose a home equity loan really comes down to the individual, the amount of debt they have and their ability to pay it back.
— Laura SterlingVice president of marketing, Georgia’s Own Credit Union
How to apply for a home equity loan
Applying for a home equity loan will feel fairly similar to the process you went through to secure your first mortgage. Here’s a rundown of what you’ll need to do:
- Know your borrowing power: Before you apply, it’s a good idea to figure out your credit score, estimate what your home is worth and calculate your equity stake. You’ll be more educated when you start comparing different lenders.
- Look at different offers: Every lender is different, so you’ll want to do your research on closing costs, rates and other pieces of the fine print. You may want to start your search at the financial institution where you have a savings or checking account, or your primary mortgage. Some lenders offer rate discounts for existing customers.
- Complete a formal loan application: You’ll need to submit paperwork verifying your income and employment, along with any other necessary documents. You’ll have to agree to allow a hard pull of your credit history and score.
- Get your home appraised: The estimate of what your home is worth isn’t the final word on your home’s actual value. Your lender probably will require an appraisal – which you will pay for – to determine the current market value of the home.
- Wait: Don’t expect to get the money fast. Vikram Gupta, executive vice-president and head of home equity at PNC Bank, says that the full underwriting process for a home equity loan can take up to 60 days – “similar to a mortgage refinance.”
- Review and sign the closing documents: You’ll need to pen your autograph on a range of paperwork about your agreement to pay the loan back, along with the serious repercussions of failing to do so.
- Receive the loan proceeds: Home equity loans are disbursed in one lump sum. Once you receive the money, you can use those funds to pay off your other debts.
Other ways to consolidate debt
Home equity loans aren’t your only option for debt consolidation. Before you hock your home, be sure to compare these routes, too:
- Personal loans: Even though personal loans carry higher interest rates than home equity loans, they don’t carry the weight of your home with them. If 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 consider transferring your balances to a new credit card that comes with an extended introductory period offering a 0% APR – meaning you won’t incur any interest charges on the amount, during a certain window of time (often up to two years). However, some card issuers may only allow you to transfer a certain amount – $7,500 or $10,000, for example. So, depending on the size of your debt load, you may still need to pay off some of it with interest. And keep an eye on what the new card’s interest will be after the promotional period ends.
- Cash-out refinance: Rather than taking out a second mortgage with a home equity loan, you can replace your original mortgage altogether – and borrow even more – with a cash-out refinance. The additional amount you can get in cash is based on the amount of home equity you have built up. This move makes the most sense if you can score a lower rate with the new loan.
- Debt consolidation loans: There are loans specifically designed for combining and paying off debts. Some of the best lenders offer rates that can rival home equity rates if your credit is excellent. However, the terms tend to be much shorter. While home equity loans may offer 20-year repayment terms, debt consolidation loans tend to work on tighter timelines – often five years or less.
- Debt management plan: Nonprofit credit counseling agencies can work with you to create a plan that’s best for your finances. An agency will negotiate your rate and payment with lenders so you can get on a plan that won’t put you in a financial bind. You’ll make one monthly payment to the counseling agency, and then it’ll pay your debt off for you. There’s a big difference between non-profit counseling companies and for-profit counseling, though, so do your research and read past customer reviews before choosing one.
When it comes to credit card debt (by far the most common type, carried by 41 percent of Americans), you can always adopt your own prioritization and payoff strategy. Two popular approaches are:
- the avalanche technique, in which you tackle the balances that have highest interest rates first
- the snowball technique, in which you attack by size, settling the smallest debts first
The requirements for a home equity loan vary from lender to lender. Generally speaking, you’ll likely need at least 15 percent equity in the home and a good credit score. To secure the lowest rate, you’ll want to take steps to boost your credit score, aiming for a 740.
Anyone who has a significant ownership stake in their home can consider using a home equity loan. If you’re planning to use one for debt consolidation, it’s important to have a solid plan in place to tackle your debts and avoid additional overspending. Ultimately, the decision to use a home equity loan comes down to having confidence in your ability to make regular on-time payments to make sure you don’t risk losing your property.
The minimum credit score for a home equity loan varies by lender. For example, BMO Harris Bank requires at least 700, while Discover will consider scores as low as 620. Many lenders set the floor at 680. Keep in mind that your credit score isn’t the only piece of the puzzle, either. Lenders will look at your entire financial picture, including your debt-to-income ratio, your earnings record and your credit history.
Additional reporting by Lena Borrelli