Home equity loans allow you to use the home’s equity to obtain a loan, with the home acting as collateral for the loan. Also called second mortgages, homeowners may take out home equity loans to help cover the cost of almost any major purchase.
While home equity loans are commonly used for renovations or a down payment on a second property, they can also be used to consolidate debt. By consolidating your debt with a home equity loan, you can reduce the interest you pay on the outstanding loans while paying them off sooner.
While effective, there are some drawbacks to this model. For example, using your home as collateral means that you may be vulnerable to foreclosure if you can’t make your new mortgage payments. Keep reading to learn more about debt consolidation, how this works with a home equity loan, and some of the pros and cons of using home equity to pay off debt.
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What Does It Mean to Consolidate Debt?
Debt consolidation is the process of taking out a new loan to pay off other outstanding debts. For example, imagine having $5,000 of outstanding credit card debt on top of $20,000 in student loans. If you were to consolidate that $25,000 of debt, you would borrow $25,000 from a single source to pay those loans off. This leaves you with a single monthly payment to a single lender, making it easier to manage your payments.
Debt consolidation may be a good idea if your existing loans have high-interest rates or you struggle to make minimum payments. By rolling your outstanding debt into a single, lower-interest loan, you may reduce the amount you pay each month while still making progress on your debt repayments.
How Does a Home Equity Loan Work?
A home equity loan allows you to access the equity in your home in the form of a new loan while using the home as collateral. Equity is calculated by subtracting the amount left on your mortgage from the market value of your home. For example, if your house is worth $500,000 and you have $300,000 left on your mortgage, your home’s equity is $200,000.
To determine how much you can borrow, lenders typically use what’s known as a combined loan-to-value (CLTV) ratio. Expressed as a percentage, the CLTV is the amount of all secured loans divided by the appraised value of your home. Lenders may offer loans anywhere between 80% and 85% CLTV.
In practice, if your home is appraised at $500,000, you could borrow up to $425,000, or 85% CLTV. If you owe $300,000 on your current mortgage, this balance is subtracted from $425,000, meaning you may be able to borrow up to $125,000 with a home equity loan.
How to Get a Home Equity Loan
You can apply for a home equity loan through your current mortgage lender or another financial institution. It’s best to compare loans from multiple lenders to find the best deal. This is because different lenders have different criteria for loan approval.
For example, lenders typically consider three critical factors in loan approvals:
- Home Equity: The difference between your current mortgage debt and the home’s market value.
- Credit Score: The rating given to you by creditors that exists on a scale of 300-850, with 300-669 considered “poor” or “fair” and 670-850 considered “good,” “very good,” or “excellent.
- Debt-to-Income Ratio (DTI): Your ratio of monthly debt to income, usually expressed as a percentage, with 40% or below considered “good.”
Different lenders assign different weights to these three factors. Some prefer DTI ratios of less than 36%, while others look for high credit scores, and some lenders focus primarily on the amount of equity in your home.
Associated Costs and Fees to Keep in Mind
Applying for a home equity loan also comes with costs and fees. These include a credit report fee, which ranges from $10 to $100, along with a home appraisal fee to determine the market value of your home and, in turn, your total equity. Appraisal fees often run between $300 and $600, depending on where you live.
Other costs include document and filing fees between $50 and $100 and title search fees between $150 and $500 to ensure there are no liens or additional claims to the property. In some cases, you may pay a loan origination fee. This may be a flat fee or a percentage of your loan, typically between 0.5% and 1%.
Taxes between 1% and 3% of your loan amount may also apply depending on local laws. In total, you can expect closing costs to run between 1% and 5% of your loan amount.
Why Consider a Home Equity Loan to Consolidate Debt?
Using a home equity loan to consolidate your debt may be a good idea if you have equity in your home, a solid credit score, and a relatively low DTI ratio.
Some of the other benefits of using a home equity loan to consolidate your debt include the following:
Lowering Your Interest Rates
You may be able to access lower interest rates with a home equity loan than with personal loans or credit cards. This is because home equity loans are considered secured debt, while personal loans and credit cards are unsecured debt. Because secured debt requires the borrower to provide collateral, an asset the lender can repossess if the loan is not repaid, lenders consider those secured loans less risky.
Home equity loans use collateral, in this case, your home, to secure your debt. If you default on payments, your lender can foreclose on your home to recoup its investment. Having this option means home equity loans are less risky for lenders, and as a result, they may offer lower interest rates.
Consolidating and Streamline What You Owe
Home equity loans let you consolidate what you owe by streamlining your debts into a single
interest rate and monthly payment. Owing a debt to a single lender with just one interest rate offers significant advantages to the borrower. Some of those advantages include the following:
- Less risk of missing a payment: Not all bills are due on the same day. Therefore, it can sometimes be easy to miss a payment if the loan’s scheduled due dates fall on different days of the month. Consolidating your debt ensures you’ve paid everything you needed to on time, every time.
- One interest rate: If you owe debts to multiple sources, each likely has an individual interest rate. Consolidating your debt allows you to pay one rate across the board, often saving you money in the long run.
- Quicker pay-off: Because consolidating your debts with a home equity loan often comes with lower interest rates, you can spend the additional money you would have paid in interest toward the principal, potentially reducing the repayment period. Alternatively, you can keep your current repayment term and make lower payments monthly if that works better for your financial situation.
Losing the House: The Big Risk of Using Home Equity to Pay Off Debt
As with any secured loan, the risk of your collateral being repossessed is real if you neglect your payments. However, unlike other secured loans that may require offering up your vehicle or an expensive piece of merchandise, non-repayment of home equity loans risk the borrower losing their house or property. In other words, you agree to forfeit your home to the lender if you cannot make your monthly payments.
Lenders may agree to extend the time between payments or work with you to find a solution if the monthly payments are too much. However, the eventual outcome of non-payment is foreclosure, meaning that your home becomes the property of the lender, who can then sell the home to recover the unpaid amount.
How to Assess If You Should Use Home Equity to Pay Off Debt
If you’re unsure about using home equity to pay off your debt, start by considering the following:
First, determine if you can comfortably afford the new loan terms once your debts are consolidated. If paying the new amount leaves you stretched thin each month, it may be worth considering another option.
Then, calculate the fees involved and compare them to the money saved. For example, if you’re spending $10,000 to obtain a new loan after taxes, interest, and fees but expect to save only $8,000 on your debt repayment, the loan may not be worth the cost.
Finally, if you determine you cannot afford the new loan terms, consider further negotiating the terms to make them more friendly for your budget. Financial institutions are willing to work with you and customize their offerings to a degree. If you’ve attempted to re-negotiate those terms and you determine it’s not possible, there are alternatives you may want to consider.
Other Debt Repayment Options
For those interested in the benefits of debt consolidation with home equity loans but unable to afford it, various other methods can be utilized to achieve the same goal. Some of those options include:
Balance transfers allow you to transfer the balance of one credit card to another and may help you better manage your debt. If you have three credit cards with balances of $3,000, $5,000, and $6,000, each with interest rates over 15%, you may be able to transfer all three of these balances to a new credit card account with more favorable terms.
Balance transfers are beneficial when you can obtain a credit card with promotional introductory interest, sometimes ranging from 0% to 5%, for a fixed period like 12 or 18 months. If you’re confident you can pay down a significant portion of your debt in that time, this may be a good choice.
Debt Management Programs
Many financial professionals or private companies also offer debt management programs. These programs can help you create a financial plan to pay back your debt, and they may also offer to contact lenders on your behalf. Look for services accredited by the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America (FCAA).
Consolidating Your Loans
Loan consolidation programs are offed by nonprofit agencies and may offer a way to consolidate your debt without taking out a new loan. These programs reach out to credit card companies and other debtors and negotiate for lower monthly payments that better align with your budget while still allowing companies to recoup some of their investments. It’s worth noting that debt consolidation programs may require you to stop using credit cards except in cases of emergency, and they typically come with a monthly fee between $30 and $50.
Taking Out a Personal Loan Instead of a Home Equity Loan
Taking out a personal loan lets you consolidate debt without using your home as collateral.
Because you are not borrowing against your home’s equity, the amount you can borrow will be lower than if you had received a home equity loan, and the interest may be higher. However, your home will not be repossessed if you neglect to repay your loans.
Taking Out a Home Equity Line of Credit (HELOC)
Another option to consider is using a HELOC for debt consolidation. Both HELOCs and home equity loans use your home as collateral and the equity in your home as the basis for your loan value. Unlike a home equity loan, a HELOC lets you borrow and pay back the money on demand rather than as a lump sum.
In contrast to home equity loans, HELOC terms are split into two phases: the draw and repayment periods. During the draw period, often 10 or 15 years, you can draw money from the line of credit and pay it back at will. However, once the draw period ends, the repayment period begins, and no more money can be obtained from this source.
If no other options are available, you can also consider declaring bankruptcy. While this eliminates your outstanding debt, it also damages your credit score for seven to ten years, making it difficult to get a new mortgage or loan. This option should be a last resort when you’re struggling to manage debt. However, for those with no other choices, it does offer an opportunity to start fresh.