Should you use a home equity loan for debt consolidation?
Debt consolidation is one of the best methods for eliminating high-interest debt. Home equity loans are a particularly good tool for doing this since they usually come with low interest rates and long repayment timelines.
A home equity loan is a loan secured by your home. You borrow against the equity in your home, which is the difference between your property’s current market value and the amount you owe on your mortgage. The money from a home equity loan can be used for nearly any purpose, such as consolidating multiple loans or credit card debts.
Should I use a home equity loan to consolidate debt?
Because home equity loans and home equity lines of credit (HELOCs) generally have low interest rates, they’re good for homeowners who could save money by refinancing their high-interest debts at a lower interest rate. For instance, you may be able to pay off a 16 percent APR credit card with a 4 percent APR home equity loan.
Home equity loans and home equity lines of credit are best for those who have significant equity available in their homes, typically at least 15 percent to 20 percent. Your home equity can be one of your most important assets; the more you build it, the more cash you have access to through loans and lines of credit.
“Borrowers who are serious about paying off their unsecured debt should consider a home equity loan for debt consolidation,” says Laura Sterling, vice president of marketing for Georgia’s Own Credit Union. “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 is usually an advantageous option.”
However, using home equity to consolidate debt is not the right choice for everyone, especially if you are not responsible with debt management or repayment. If you make late payments on a home equity loan, you could put your home at risk of foreclosure. And because most HELOCs have variable interest rates, you must plan for the possibility of higher monthly payments.
Pros of using home equity for debt consolidation
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.
“Many people have a hard time juggling multiple bills every month, and making sure all are paid on time,” says Joseph Toms, president and chief investment officer of Freedom Financial Asset Management, a debt relief company. “Having just one payment to take care of can ease the stress and help many people ensure on-time payment.”
Why this matters: Simplifying your finances is always a good thing. Having only one monthly payment decreases your odds of missing a payment.
Lower interest rate
A home equity loan generally comes with a lower interest rate than other types of loan products 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 off those debts.
Why this matters: A lower interest rate means less total interest paid over the course of the loan.
Make 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.
Why this matters: Lower monthly payments can make paying debt off more reasonable on a tight budget. However, extending the length of your loan term could cause you to pay more interest overall.
Cons of using home equity for debt consolidation
While a home equity loan for debt consolidation might work for some people, it’s not necessarily the best choice for everyone.
Your home is collateral
The main consideration in using your home’s equity for debt consolidation is that your home serves as collateral for a home equity loan. This means that if you default on your new home equity loan, you may face foreclosure. If you’re having trouble making existing payments, you may want to find other ways to consolidate debt.
Why this matters: A home equity loan is secured by your home, so if you fall behind on the payments for it, you may lose your home.
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.
Why this matters: If you consolidate your debt before you’ve addressed the underlying concerns that caused you to go into debt in the first place, you may find yourself right back where you started.
Since a home equity loan uses your home’s current value to calculate how much you can borrow, 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. If you have a lot of debt to consolidate, paying these extra fees may still make sense, but it’s wise to compare the fees you would have to pay with the amount you’d ultimately save in interest.
Why this matters: Make sure that the fees for debt consolidation don’t outweigh the savings.
How do I get a home equity loan for debt consolidation?
Applying for a home equity loan for debt consolidation is similar to applying for a mortgage. You will be required to provide income and employment information, sign closing documents and possibly have your home appraised. There are no differences in the application process for a home equity loan or a HELOC.
“The process could take up to 60 days, similar to a mortgage refinance,” says Vikram Gupta, head of home equity for PNC Bank. “At closing, the lender can often send the debt payments directly to other lenders and consolidate the debt into the new home equity loan.”
The primary differences between a home equity loan and a HELOC are how borrowers get their funds and how interest is charged.
A home equity loan has a fixed rate and is disbursed to the borrower in one lump sum. The borrower begins making regular monthly repayments immediately.
With a HELOC, the interest rate is typically variable. The loan starts with a draw period generally lasting 10 years, during which the borrower can draw on the line of credit as needed and make interest-only payments. Once the draw period ends, the repayment period begins. The borrower then begins paying on both the principal and interest for a term that usually lasts 20 years.
Sterling says that while HELOCs offer more flexibility, home equity loans provide the stability of fixed-rate payments for those who know how much they need to borrow.
Other ways to consolidate debt
A home equity loan isn’t the only choice you have for debt consolidation. Before choosing it, compare all of your options.
- 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 transfer your balances to a 0 percent APR balance transfer 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 card issuers 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. 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. You’ll make one monthly payment to the counseling agency, and then it’ll pay your debt off for you.
How do I get started?
If you’ve decided that a home equity loan is your best option for consolidating debt, start by comparing lenders, offers, rates and terms. If you can’t get better terms or a lower interest rate than what you have on your existing debt, 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 your finances up for a more secure future.