Should You Use a Home Equity Loan for Debt Consolidation?

Debt consolidation can be an effective strategy for simplifying payments and saving money on interest. One way to consolidate debt is by taking out a home equity loan. But is tapping your home equity the right move? In this comprehensive guide, we’ll discuss when a home equity loan makes sense for consolidating debt vs. when other methods may be better.

What is a Home Equity Loan?

A home equity loan is a type of second mortgage that allows you to borrow against the equity in your home Equity is the difference between your home’s market value and the amount you still owe on your mortgage

For example, if your home is worth $300,000 and you owe $180000 on your mortgage, you have $120000 in equity ($300,000 – $180,000 = $120,000). With a home equity loan, you can tap into a portion of that equity – usually up to 85% – to get a lump sum of cash.

Home equity loans have fixed interest rates and set repayment terms, usually between 5-30 years. You’ll make fixed monthly payments on the loan until it’s paid off. The interest rate is usually lower than credit cards but higher than your first mortgage.

When Does it Make Sense to Use Home Equity to Consolidate Debt?

A home equity loan can be a smart way to consolidate debt if you meet certain criteria:

• You have significant equity built up – To qualify, you’ll generally need at least 15-20% equity available to tap. The more equity you have, the lower your loan-to-value ratio will be, which lenders prefer.

• Your credit score is good or excellent – Home equity loans require decent credit, usually 680+ FICO. The higher your score, the better rate you can get.

• Interest rates on your debts are high – Good candidates for consolidation have expensive credit card or personal loan balances charging 15% APR or more.

• You have a steady income – Lenders want to see you have reliable income to comfortably handle the new monthly payment. Your total debt-to-income ratio shouldn’t exceed 43%.

• You plan to stay in your home long-term – These loans can take years to pay off, so they work best if you don’t plan to move soon.

• You can get a much lower rate – The goal is to end up with a significantly lower overall interest rate to save money.

The Pros of Using Home Equity to Consolidate Debt

If your situation lines up with the criteria above, here are some potential benefits of tapping home equity to consolidate debt:

• Lower interest rate – Home equity loans and lines of credit typically have much lower interest rates than credit cards or personal loans, so you can save substantially on interest costs over time.

• Simplified payments – Consolidating multiple debts into one home equity loan results in just one monthly payment to manage.

• Access significant funds – For homeowners with tappable equity, a home equity loan can provide tens of thousands in available financing or more.

• Flexibility – Unlike refinancing, you can generally qualify for a home equity loan even with a low appraisal or little to no home price appreciation.

• Potentially tax deductible – If you itemize, the interest may be tax deductible, saving you more money (consult a tax pro).

The Cons of Using Home Equity to Consolidate Debt

There are also some potential downsides to be aware of:

• Closing costs – You’ll pay closing costs of 2-5% of the loan amount. These upfront fees are higher than other options like balance transfer cards.

• Risks your home – If you default, the lender can foreclose and force a sale to recoup their money.

• Can extend your total debt term – Adding another 15-30 year loan onto your existing mortgage keeps you in debt longer.

• Variable rates – Home equity lines of credit have variable rates that could spike and lead to higher payments.

• Home values may decline – If home prices drop, your equity could shrink or be eliminated, putting you “underwater”.

• Prepayment penalties – Some lenders charge fees if you pay off the loan early. Make sure to ask.

What is the Home Equity Loan Process?

If you decide a home equity loan is the right debt consolidation option for your situation, here are the main steps to get one:

1. Check your home equity – Request an appraisal to confirm how much tappable equity you have available. Online calculators can also provide estimates.

2. Check your credit score – It’s wise to check your credit before applying so you know where you stand. Scores of 680+ generally qualify.

3. Compare lender offers – Look at quotes from multiple lenders, including banks, credit unions, and online lenders. Compare interest rates, fees, and terms.

4. Submit your application – Apply with your chosen lender and submit all required documentation (paystubs, tax returns, bank statements, etc.).

5. Get approved – It takes 1-2 weeks for the lender to verify your income, assets, credit, and eligibility. You’ll get a loan decision.

6. Close on the loan – If approved, you’ll get a Closing Disclosure outlining the costs. Then sign the final paperwork to secure the funds.

7. Pay off debts – Once funded, use the lump sum payout to pay off the balances you want to consolidate.

Debt Consolidation Alternatives to Home Equity Loans

While home equity loans are one option, they aren’t the only way to consolidate debt. Depending on your specific situation, here are some other methods to consider:

• Balance transfer credit card – Transfer high-interest balances to a card with a 0% intro APR for 12-18 months to save substantially on interest.

• Cash-out mortgage refinance – Refinancing taps home equity while replacing your existing first mortgage with a new one. This lets you wrap everything into one loan.

• 401(k) loan – Borrowing from your 401(k) avoids credit checks and may offer favorable rates. Just beware the risks, like losing employer match contributions while repaying the loan.

• Personal loan – An unsecured personal loan doesn’t put your home at risk. Look for low, fixed rates from online lenders.

• Debt management plan – Credit counseling agencies can negotiate lower interest rates and consolidate debts into one monthly payment.

• Ask creditors for better terms – You may be able to negotiate a lower interest rate or more favorable repayment terms directly with creditors.

Key Takeaways: When to Use Home Equity for Consolidation

• A home equity loan or HELOC can provide loan amounts of tens of thousands of dollars or more at relatively low interest rates compared to other options. This can lead to substantial interest savings when consolidating high-rate debts.

• However, borrowing against your home is risky. Make sure you have sufficient equity, good credit, steady income, and a realistic plan to repay the loan within the set timeframe.

• Explore all your consolidation possibilities and run the numbers to see which method may offer the lowest overall repayment cost and least risk based on your specific financial situation.

• A home equity loan is best suited for certain borrowers who meet the ideal criteria for approval, have prime equity available to tap, and can achieve significant monthly savings from lowering their interest costs. But it likely isn’t the optimal choice for everyone. Consider both the pros and cons carefully.