If you’ve been watching your credit card debt grow recently, you’re not alone. Nearly half of cardholders carry a balance month to month, and there are about 54 million adults in debt for a year or more, according to a recent survey by Bankrate. This is tough especially as credit card interest rates – like interest rates in general – have been continuously rising due to the Federal Reserve’s ongoing efforts to control inflation.
What is a 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 certain amount of money that you pay back in installments, the same amount every month.
What is a Home Equity Line of Credit?
A home equity line of credit (HELOC) works like a credit card – you have access to a credit limit that you can draw from and pay back as needed over a specified period. It carries a variable interest rate, so your payments may change.
Using a home equity loan to consolidate debt is a viable option for homeowners for several reasons.
Advantages of Using Home Equity to Consolidate Debt
Using your home equity to consolidate debt can be a smart move for several reasons.
Streamlined Single Payment
When you consolidate your debt using your home equity, you can simplify your life. Instead of making one credit card payment on the 15th of the month, another on the 20th, and your personal loan payment on the 27th, you’ll have one due date to remember each month. Since timely payments are a crucial part of your credit history, this can help avoid the chance of missing a payment due to calendar confusion.
Lower Interest Rate
A home equity loan typically comes with a lower interest rate than other types of loans since your home serves as collateral for the loan. If you have debt on credit cards, a personal loan, student loans, or other debt, consolidating using a home equity loan can make repayment cheaper. Additionally, a home equity loan is usually fixed-rate, so your payment will always be the same. This is a significant difference from credit cards, which carry a variable interest rate. (Note: Most home equity lines of credit (HELOCs) also have fluctuating rates, although you can sometimes switch to a fixed-rate HELOC. This makes HELOCs for debt consolidation worth considering.)
Lower Monthly Payments
Using a home equity loan to consolidate debt will typically lower your monthly payments since you will likely have a lower interest rate and a longer loan term. If you have a tight monthly budget, the money you save each month may be just what you need to get out of debt.
Disadvantages of Using Home Equity to Consolidate Debt
While a home equity loan may work for some people to consolidate debt, it may not necessarily be the best option for everyone.
Secured by the Home
Laura Sterling, vice president of marketing at Georgia’s Own Credit Union, says, “Because the borrower’s home is used as collateral, borrowers must be cautious. Otherwise, they risk losing their home.” The potential risk of foreclosure should be kept in mind if you are considering applying for a home equity loan. If you sell your home while the loan is still outstanding, you will need to pay it off in full, just as you would with the original mortgage.
Increased Debt
While a home equity loan can consolidate your debt, it won’t be helpful if you don’t address the spending that caused the debt to accumulate in the first place. For example, if you have a significant credit card debt, pay it off, and then continue to accumulate more debt on your credit cards, you make your debt situation worse: now you’ll owe the home equity loan payment plus credit card payments. It’s crucial to tackle the root cause of your debt before committing to another loan.
Fees
Possible
You may be responsible for closing costs – small additional expenses imposed by the loan. Creation fees, home appraisal fees (to verify the value of your home), credit report fees – to mention just a few. These costs are lower than those imposed on a mortgage, but they do add up. If you have a lot of debt to consolidate, it may be worth paying these additional fees and comparing them to the amount you will ultimately save in interest with the loan on credit card bills.
What types of debt should you consolidate using a home equity loan?
These are the types of debt that are well-suited for repayment using home equity loans.
Credit Cards
Many homeowners use a home equity loan to pay off their outstanding credit card balance – after home renovations, this is the most common application. The reason is simple: the interest rates on home equity loans (currently around 9 percent) work out to half of those found on credit cards (over 20 percent). This means that you can pay off your credit cards in one payment, faster and cheaper, by making the minimum payment on the credit card each month.
Personal Loans
Personal loans vary widely, but your loan’s interest rate is likely to be higher than that of a home equity loan, especially if it is unsecured. Unsecured loans generally cost more than secured loans because the lender takes on more risk. Home equity loans typically offer much longer repayment periods – up to 20 years – than personal loans as well.
Healthcare Bills
Healthcare expenses can arise unexpectedly and can accumulate very quickly, especially if they involve a hospital stay. You can use your home equity to cover those medical costs if a large amount isn’t covered by health insurance. And if you choose a HELOC, you can benefit from flexible repayment amounts (most allow for interest-only payments during the initial draw periods).
Student Loans / Education Bills
If you need to pay off student loans, borrowing against your home can be a possible way to do so – as long as the home equity loan offers a lower interest rate or more favorable terms. However, you won’t be able to take advantage of the student loan interest deduction, and if the student loan is a federal loan, you may lose other potential benefits, such as forgiveness or income-based repayment options. The best option may be to directly pay college bills using a HELOC, which allows you to withdraw funds in installments and only pay interest on the amount borrowed.
What types 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.
Car Loans
A car is a depreciating asset, meaning that your home equity loan balance could be larger than the value of your car within a few years. Also, car loan rates are currently competitive with home equity loan rates.
Vacations / Luxury Items
While it might seem tempting, it’s not a good idea to use a home equity loan to take a vacation or buy other recreational items. If you have to take out a loan, it means your income cannot support your spending, and this bad habit could pull you deeper into debt. Before spending, remember the length of the loan; you will still be paying it off long after the good times have ended.
Mortgage
Since mortgage rates are generally lower than home equity rates, it is rare for it to make sense to pay off your primary mortgage using a home equity loan. In some cases, you might consider refinancing instead (see cash-out refinancing in “Other Ways to Consolidate Debt” below).
Investments
Investing
important, but going into debt to do so is a debatable step – especially in light of the current high cost of borrowing, which rivals any returns in the stock market (it was a good strategy a few years ago when loan interest rates were at their historical lows). A crash in stock prices can wipe out real estate equities that you spent years building. Avoid using a home equity loan for investments: it’s better to use savings or earned income, especially if you can invest through your company’s 401(k) plan.
How to Apply for a Home Equity Loan
Applying for a home equity loan will be somewhat similar to the process you went through for your first mortgage. Here’s a summary of what you need to do:
Know Your Borrowing Power
Before applying, it’s a good idea to check your credit score, estimate the value of your home, and calculate your equity. You’ll be more educated when you start comparing different lenders.
Consider Different Offers
Every lender is different, so you’ll want to look for closing costs, interest rates, and other details in the fine print. You may want to start your search with the financial institution where you have a savings or checking account, or your existing mortgage. Some lenders offer rate discounts for existing customers.
Complete a Formal Loan Application
You will need to provide documents that verify your income and employment, along with any other necessary paperwork. You’ll need to agree to allow a hard pull on your credit history and score.
Have Your Home Appraised
Estimating the value of your home is not the final word on the actual value of your home. Your lender will likely require an appraisal – which you’ll pay for – to determine the current market value of the home.
Wait
Don’t expect to get the money quickly. Vikram Gupta, senior executive vice president and head of home equity at PNC Bank, states that the full verification process for a home equity loan can take up to 60 days – “similar to mortgage refinancing.”
Review and Sign Closing Documents
You’ll need to sign a set of papers regarding your agreement to repay the loan, along with the serious consequences of failing to do so.
Receive Loan Proceeds
Home equity loans are disbursed in a lump sum. Once you receive the funds, you can use that money to pay off your other debts.
Other Ways to Consolidate Debt
Home equity loans are not your only option for consolidating debt. Before you mortgage your home, be sure to compare these methods as well:
Personal Loans
While personal loans carry higher interest rates than home equity loans, they do not put your home at risk. If an emergency occurs and you can’t repay, you won’t lose your home with a personal loan.
Balance Transfer Credit Cards
If most of your debt consists of credit cards, you might consider transferring balances to a new credit card that comes with an extended introductory period offering a 0% interest rate – meaning you won’t pay any interest on the amount for a certain period (often up to two years). However, some card companies may only allow you to transfer a certain amount – such as $7,500 or $10,000, for example. So, depending on the size of your debt, you may need to pay off some with interest. Keep track of what the interest on the new card will be after the promotional period ends.
Cash-Out Refinancing
Instead of taking a second loan with a home equity loan, you can replace the original mortgage entirely – and borrow more – through cash-out refinancing. The additional amount you can get in cash is based on how much equity you’ve built up. This option is best if you can get a lower rate with the new loan.
Loans
Debt Consolidation
There are loans specifically designed for consolidating and paying off debts. Some of the best lenders offer rates that can compete with home equity rates if your credit score is excellent. However, the term is much shorter. While home equity loans may offer repayment periods of up to 20 years, debt consolidation loans operate on much stricter timelines – often five years or less.
Debt Management Plan
Non-profit credit counseling agencies can work with you to create a plan that fits your financial situation. The agency will negotiate the interest rate and payment with creditors so you can obtain a plan that won’t put you in financial trouble. You will make a single monthly payment to the counseling agency, and then they will pay off your debts. There is a big difference between non-profit counseling agencies and for-profit counseling companies, so do your research and read reviews from previous clients before choosing one.
Regarding credit card debt (the most common type with 41 percent of Americans), you can always adopt your own prioritization and repayment strategy. There are two common approaches:
- Debt avalanche method, where you tackle the balances with the highest interest rates first
- Debt snowball method, where you attack by size, paying off the smaller debts first
Frequently Asked Questions
Who is eligible for a home equity loan?
Requirements for home equity loans vary from lender to lender. Generally, you will likely need to have at least 15 percent equity in your home and a good credit score. To get the lowest rate, you will want to take steps to improve your credit score, targeting 740.
Who should use a home equity loan?
Anyone with a significant equity stake in their home may consider using a home equity loan. If you plan to use it for debt consolidation, it’s important to have a solid plan in place to manage your debts and avoid additional overspending. Ultimately, the decision to use a home equity loan comes down to your confidence in your ability to make regular, timely payments to ensure you don’t risk losing your property.
What is the minimum credit score required to get a home equity loan?
Source: https://www.aol.com/home-equity-loan-debt-consolidation-183312521.html
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