At a Glance
Tapping into your home’s equity, whether through a home equity loan or a home equity line of credit (HELOC), is one way to consolidate debt. This article will go over the pros and cons of using a home equity loan to consolidate debt:
What is a home equity loan?
A home equity loan is basically a second mortgage that you take out on your home. Home equity loans are given in a one time lump-sum and often have lower-interest rates than other debt consolidation methods. They are paid monthly until the loan has been paid back in full.
What is a HELOC?
A home equity line of credit is a revolving line of credit that you take out on your home. Similar to a credit card, you can draw from your HELOC whenever you need access to cash. The amount you can take out, and the interest rate, varies depending on factors like your credit score, income, and how much equity you have in your home.
How to apply for a home equity loan for debt consolidation
Before applying for a home equity loan, make sure to:
- Calculate your home’s equity: Home equity is your home’s current market value minus the amount you still owe. Check how much your debts amount to and make sure that your home equity will be sufficient to cover the cost.
- Obtain your credit score: While your credit score doesn’t need to be sky-high to qualify for a home equity loan, you probably won’t qualify if it’s poor (you’ll likely need at least a 620). Credit score minimums vary with lenders. Learn how to get a home equity loan with bad credit.
- Compare lenders: Compare interest rates, terms, and fees when deciding which lender to use.
How much can I borrow?
Most lenders require you to maintain a 20% equity cushion of your home’s value, meaning you can borrow up to 80% of your home’s appraised value, minus the amount you still owe.
Pros of using a home equity loan for debt consolidation
Pros of using a home equity loan include:
Low interest rates
: Interest rates on home equity loans are much lower than other types of debt, such as credit cards. This is because home equity loans are secured loans, meaning that you’re offering collateral to the lender.
Lower monthly payments
: Home equity loans typically have longer repayment periods than other types of loans, so your monthly payments could be lowered.
Only one payment per month
: Instead of worrying about due dates and payments for multiple bills, you’ll only have to worry about paying one per month.
: Your interest can be tax deductible if your loan is being used to improve your home’s value i.e. building an addition or renovating the kitchen. Anything else the loan is used for won’t be deductible.
You don’t need excellent credit
: Because you’re offering your home as collateral to the lender, you pose less risk to the lender and typically don’t need a super high credit score to qualify. However, higher scores will generally allow for better interest rates.
Cons of using a home equity loan for debt consolidation
Cons of using a home equity loan include:
- You could lose your home: Your home will be used as collateral for the loan. If you miss payments, your house could go into foreclosure.
- Home value could decrease: if your home value goes down, and you suddenly owe more money that your home is worth, you could be forced to forfeit your property to the bank.
- Extra fees: You might have to pay for extra expenses like a home appraisal and closing costs.
- Not a quick process: It can take 30 days or even longer to get the paperwork for your home equity loan, so if you’re in a rush to consolidate this may not be the best option for you.
When a home equity loan makes sense
Using a home equity loan makes sense if:
Consolidating your debts will save you money
Check and make sure that your new interest rate and repayment period will actually be saving you money.
Your debt isn’t too extreme
Home equity loans work best for moderate debt. If your debt is so deep that a home equity loan won’t get you out of it, you may want to consider other debt relief options such as bankruptcy.
When a home equity loan isn’t a good idea
You should probably consider another method of debt consolidation if:
Your spending habits are the real problem
Using a home equity loan to pay off your debt doesn’t make the debt disappear. If your spending habits are the reason you’re in debt and you continue to mismanage your credit card use, you’ll just have additional debt on top of your home equity loan.
There’s a chance you can’t pay back the loan
A home equity loan is not a good choice if there’s any chance you won’t be able to pay back your loan as you could lose your home.
Should I use a home equity loan or a HELOC?
There are four main differences between home equity loans and HELOCs that you should be aware of when deciding which is better for you.
Home equity loans pay out in a lump sum, while a HELOC allows you to withdraw money as you need it.
Home equity loans charge interest at a fixed-rate, so you’ll have a clear and definite repayment schedule. HELOCs charge variable interest rates, so the rates are based on the standard index (meaning that they are subject to change based on the U.S. economy).
Home equity loans don’t carry annual fees, while some HELOCs have transaction fees, as well as annual fees during the repayment period.
Since home equity loans come in lump sums, you pay interest on everything, even if you don’t wind up using the full amount. With HELOCs, you only pay interest on the money you actually need.