Should You Use A Home Equity Loan To Pay Debts?

If you’ve noticed an increase in your credit card bill lately, you’re not alone. According to Bankrate’s Credit Card Debt Survey, half (50%) of credit card owners carry a credit card balance each month. And the vast majority of people who carry balances have been carrying them around for at least the past 12 months. 60% of credit card holders have had credit card debt for at least a year. What’s worse, many of them don’t have a strategy to pay off that balance. Only 42 percent of Americans with credit card debt have a plan to pay off their credit card debt.

If a homeowner is struggling with a ballooning balance, a home equity loan can be an effective solution. The average interest rates on home equity loans and their lines of credit, HELOCs, are much lower than the interest rates associated with credit cards and unsecured personal loans. According to Bankrate’s latest statistics, that interest rate is now less than 9%, but the average interest rate on credit cards is still over 20%.

However, this type of financing comes with significant risks. If you fail to make payments, your home may be repossessed. Here’s what you need to know to determine whether a home equity loan will help you pay off your expensive debt.

Why use a home equity loan to pay off debt?

Utilizing a home equity loan or HELOC to pay off debt is a viable option for those who own a large portion of their property outright without a mortgage, as interest rates are lower than other loans. According to Bankrate’s Home Equity Insights survey, 30 percent of homeowners agree that debt consolidation is a good reason to leverage home equity.

Laura Sterling, vice president of marketing for Own Credit Union of Georgia, said home equity loans are more affordable than unsecured loans. “If a consumer has significant equity in their home, has the discipline to stay within their means when it comes to borrowing, and is in a healthy financial position, it can be a cost-effective way to repay debt,” Sterling said. says. .

But, he added, “it takes discipline and comes with risks.” If you consistently fall behind on your home equity loan payments (or worse, miss payments altogether), your home may be at risk of foreclosure.

Advantages of using home equity to consolidate debt

Using your home equity for debt consolidation is a smart choice for a variety of reasons.

One streamlined payment

Consolidating your debt using your home equity can simplify your life. Instead of paying one credit card bill on the 15th, another on the 20th, and a personal loan payment on the 27th, you only have to remember one due date each month. Masu. On-time payments are an important factor in your credit score, so this eliminates the possibility of missed payments due to calendar confusion.

Lower (and fixed) interest rates

Because your home acts as collateral, home equity loans typically have lower interest rates than other unsecured forms of debt that are not backed by anything. As of October 2024, home equity loan interest rates average less than 8.5%, making them much more attractive than the average credit card interest rate of 20.55%.

Additionally, home equity loans have fixed interest rates, so your payments will always be the same. This is a big difference from credit cards, which have variable annual interest rates. (Note: Most home equity lines of credit also have variable interest rates, but in some cases you can convert to a fixed rate HELOC.)

lower monthly payments

When you use a home equity loan to consolidate your debt, your monthly payments will generally be lower because you’re likely to get a lower interest rate and a longer loan term. If you’re on a tight monthly budget, the money you save each month could be exactly the amount you need to get out of debt.

Disadvantages of using home equity to consolidate debt

While a home equity loan for debt consolidation may work for some people, it’s not necessarily the best choice for everyone.

house is in danger

There’s a reason why interest rates on home equity loans are lower than many other borrowing routes. If you don’t pay it back, the lender will repossess your home, which gives you some pretty good peace of mind. If you are considering applying for a home equity loan, the possibility of foreclosure should be a top consideration. If you sell your home while the loan is still outstanding, you will need to pay off the entire amount at once, just like you would pay off your original mortgage.

Increase in debt burden

Home equity loans can consolidate debt, but they’re only useful if you limit the expenses that caused the debt to grow in the first place. If you clear your card balance and immediately start charging it again, you’ll end up in even more debt. In addition to paying off your credit cards, you’ll also be responsible for paying your mortgage. It’s important to address the root cause of your debt before taking out a new loan.

To qualify for these loans, a borrower must have a healthy amount of home equity (at least 20 percent ownership of the home, preferably closer to 40 percent or 50 percent). However, keep in mind that borrowing against your home’s equity essentially exhausts your ownership rights. In other words, your assets have decreased and your obligations have increased. This won’t improve your debt-to-income ratio or your loan-to-value ratio, two aspects of your financial profile that lenders often look at.

Fee

You may have to pay closing costs (various small additional costs charged by the lender, such as loan fees, home appraisal fees (to find out what your home is worth), and credit report fees, just to name a few). there is. These expenses tend to be small compared to mortgages, but they definitely add up. If you have a large amount of debt to consolidate, it may still make sense to pay these additional fees, but you should budget for those costs and make sure that the interest on your loan is less than your credit card bill. It is wise to compare the amount you can save.

What kind of debt should I consolidate with a home equity loan?

These are the types of debts that are suitable for repayment with a home equity loan.

credit card

Many homeowners take out home equity loans to settle outstanding credit card balances. This is the most common use after home renovation. The reason is simple. Interest rates on home equity loans (currently averaging 8 to 9 percent) are at least half the interest rates on credit cards (20 percent or more). This means you can pay off your credit cards faster and cheaper in one lump sum, rather than making the minimum credit card payment each month.

personal loan

There are many different types of personal loans, but interest rates can be higher than home equity loans, especially if they’re unsecured. Unsecured loans are typically more expensive than secured loans because the lender takes on more risk. Home equity loans often offer much longer repayment terms (up to 20 years) than personal loans.

medical expenses

According to a recent study by the Consumer Financial Protection Bureau, 15 million Americans have medical debt on their credit report, with an average balance of more than $3,100. If you have large medical expenses that are not covered by your health insurance, you can use your home equity to cover them. If you choose a HELOC, you can also benefit from flexible repayments (in most cases, you can make interest-only payments during the initial withdrawal period). However, before making any decisions about medical debt, ask your healthcare provider if a lower-cost payment plan is available.

Student loans/educational expenses

If you need to pay off student loans, one possible option is to borrow money from your home if a home equity loan offers lower interest rates or other more favorable terms. However, you won’t be able to take advantage of the student loan tax deduction, and if it’s a federal loan, you’ll lose out on other potential benefits, such as forgiveness or income-driven repayment options. A better option is to pay for college tuition directly with your HELOC. With a HELOC, you only earn interest on the amount you borrow, and you can withdraw your funds in installments.

What debts should not be consolidated using a home equity loan?

There are times when a home equity loan may not be the best idea.

car loan

Cars are depreciable products, meaning their value decreases over time. This means that your mortgage balance could exceed the value of your car after a few years. Additionally, interest rates on auto loans are now competitive with home equity loans.

vacation/luxury items

Although appealing, taking out a home equity loan for a vacation or big-ticket item is not a good idea. Having to take out a loan means your income can’t keep up with your expenses, and this bad habit can get you into debt. Before you splurge, keep in mind how long your loan will last. You’ll probably continue to pay it back long after the good times are over.

mortgage loan

Mortgage interest rates are generally lower than home equity rates, so it makes little sense to pay off your primary mortgage with a HE loan or HELOC. In some cases, you may want to consider refinancing instead (see ‘Other debt consolidation options’ below).

investment

Home Equity Insights research shows that a surprising number of millennial homeowners (30%) consider other investments (other than a home) to be a good reason to leverage home equity. It turns out. Investing is important, but borrowing money to do so is controversial. Especially given the current high cost of borrowing, which rivals stock market returns (which was probably a good strategy a few years ago when loan rates were at historic lows). And a crash in stock prices can wipe out the home equity you’ve spent years building. Don’t use home equity loans to invest. It’s better to use your savings or earned income, especially if you can invest it through your company’s 401(k) plan.

How to apply for a home equity loan

Applying for a home equity loan feels much like the process you went through to secure your first mortgage. Here’s an overview of what you need to do:

1. Know your borrowing power: Before you apply, it’s a good idea to know your credit score, estimate the value of your home, and calculate your equity. You will become more knowledgeable as you start comparing different lenders.
2. Look at the different offers. Each financial institution is different, so you’ll need to research closing costs, interest rates, and other details. You may want to start your search with the financial institution where you hold your savings account, checking account, or primary mortgage. Some financial institutions offer interest rate discounts to existing customers.
3. Complete a formal loan application. You will need to provide proof of income and employment as well as other required documents. You must agree to allow us to compulsorily retrieve your credit history and score.
4. Get your home appraised: Your home value estimate is not the final judgment as to the actual value of your home. Your lender will likely require an appraisal that you pay to determine the home’s current market value. However, more and more lenders are using AVM (Automated Valuation Model) to bypass the appraisal process.
5. hang on: Don’t expect to get the money right away. While some financial institutions offer relatively quick funding for HELOCs, such as Figure, which can disburse funds in as little as five business days, getting full approval for a home equity loan takes longer. , which can feel closer to your first mortgage timeline of up to eight weeks. Waiting.
6. Review and sign the closing documents. You will need to sign various documents agreeing to repay the loan and the serious consequences of failing to do so.
7. Receive loan funds: Home equity loans are disbursed in bulk. Once you receive the money, you can use the funds to pay off other debts.

Other ways to consolidate your debts

Home equity loans aren’t the only option for debt consolidation. Before building a house, be sure to compare the following routes as well.

• Personal loan: Personal loans have higher interest rates than home equity loans, but they don’t carry the weight of a home. If an emergency occurs and you can’t make your payments, a personal loan will keep you from losing your home.
• Balance transfer credit card: If most of your debt is through credit cards, you might consider transferring your balance to a new credit card with an extended introductory period and 0% APR. A specific period of time (often up to two years). However, some card issuers may only allow you to transfer certain amounts, such as $7,500 or $10,000. Therefore, depending on the amount of your debt, you may need to repay some of it with interest. And keep an eye on what the new card interest will be after the promotional period ends.
• Cash-out refinance: Rather than taking out a second mortgage with a home equity loan, a cash-out refinance can completely replace your original mortgage and allow you to borrow more money. The additional amount you can receive in cash is based on the amount of home equity you’ve built up. This move makes the most sense if you can get a lower interest rate on your new loan.
• Debt consolidation loan: There are loans that are specifically designed to pay off your debts all at once. Some good lenders will offer interest rates comparable to home equity rates if you have good credit. However, the duration tends to be much shorter. Home equity loans may offer a 20-year repayment term, while debt consolidation loans tend to work on a tighter schedule, often five years or less.
• Debt management plan: A nonprofit credit counseling agency can work with you to create a plan that’s best for your finances. Your agent will negotiate interest rates and payments with your lender, so you can get a plan that won’t put you in financial constraint. Once a month, you make payments to the counseling agency and the debt is repaid. However, there are significant differences between nonprofit and for-profit counseling companies, so do your research and read past customer reviews before choosing one.

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