Thinking about taking out a home equity loan or a home equity line of credit? Join the club. As homeowners have seen their property values soar over the past three years, many have turned to home equity lending products to access cash. In fact, Citizens Bank saw the highest number of HELOC originations in its history last year.
Why are so many people taking out home equity loans? One of the most common uses is to cover the costs of making that home more comfortable with a big home improvement project, or more efficient by adding solar panels. In other cases, however, it may be part of a plan to tackle outstanding debts. Home equity rates are significantly lower than credit card interest rates -- 8.08% for home equity loans versus more than 20% for credit cards, according to the latest figures from CNET’s sister site Bankrate -- so it can add up to some sizable savings.
Read on to determine if a home equity loan is a wise move for your debt consolidation strategy.
Should you use home equity to consolidate debt?
Some of the reasons to borrow against your home equity to consolidate debt include paying off higher-interest consumer debt such as credit cards or student loans. Essentially, you can use the funds for whatever you want -- which is why it’s critical to make sure you can manage your money responsibly, such a high line of credit over an extended period of time. Translation: A home equity loan isn’t for covering the costs of your summer vacation, your holiday gifts or any other “fun” spending to enhance your lifestyle. If you borrow against your home, you need to make each of those dollars contribute to making your personal finances better -- not worse.
Pros and cons of using home equity to consolidate debt
Pros
Lower interest rate: Home equity loans tend to have low interest rates, which can save you money over the course of your loan term. For example, let’s say you’re carrying a $10,000 balance on a credit card with a 25% APR. If you decide to pay off with a 9% HELOC, you can save thousands of dollars in interest over the lifetime of your loan.
One lower monthly payment: Combining all of your debts into one monthly payment makes paying off your debt a more manageable and streamlined process and should lessen the amount you pay every month. For example, if you’re struggling to keep up with reminders for different payment dates on four different bills, one loan can simplify your life.
Home renovation tax deduction: If you use your home equity loan for home renovations or repairs, you can deduct it from your taxes.
Cons
You can lose your home: The most obvious downside to a home equity loan is that your bank or lender can repossess your property if you fail to make payments or default on your loan for any reason.
You may increase your debt: If you don’t properly manage your loan and other debts moving forward, you can also end up in more debt. As in, if you pay off credit card debt but don’t change your spending habits, you’ll end up on the hook for credit card payments in addition to your home equity loan payments, which cancels out the reason you took out the loan in the first place.
Loan limits: If you have a low or less-than-stellar credit score, or you’re already carrying a lot of debt, you may not have access to a very high loan amount, and the interest rate a lender will charge you will likely be higher, too.
Rising rates: Home equity borrowing isn’t nearly as cheap as it was a year ago. The Federal Reserve has been hiking rates, and home equity products have followed that upward trajectory. So, while home equity borrowing is still cheaper than a credit card, it’s not a slam dunk. Plus, if you have a HELOC, you’ll be subject to potential rate increases further down the road.
Alternative ways to consolidate debt
Before you commit to a home equity loan or HELOC and put your house on the line, consider the other types of financing available to you. Rather than taking out a second mortgage, you can consider options such as a 0% interest credit card or a personal loan, which doesn’t come with the risk of losing your home -- though they may come with higher interest rates since they are unsecured loans.
Balance transfer credit cards
Some balance transfer credit cards offer a 0% interest rate for an introductory period, which can range anywhere from six to 21 months. If you can develop an aggressive strategy to rid yourself of the balance within that given time, you won’t pay another dollar in interest. However, if you don’t pay it off by the end of the introductory period, your interest rate will rise, and you’ll be paying a much higher annual percentage rate.
Personal loans
You can apply for a personal loan from a bank or other financial institution. You may pay a higher interest rate, but you won’t have to put your home up as collateral to secure the loan.
Overall debt management
Another option is to enter into credit counseling. You can work with a nonprofit agency that charges little to no fees, and your credit score won’t be negatively affected. Counseling services can negotiate lower balances and interest rates with your creditors on your behalf, as well as create a plan for you to stay out of debt. Beware of debt consolidation scams and make sure you work with a reputable organization if you go this route.
How to apply for a home equity loan to consolidate debt
Merely owning your home won’t be enough to be automatically approved for a home equity loan or a HELOC. You’ll need to make sure you have enough equity in the property -- typically 15% to 20%, although some lenders will consider as low as 10%. Take a look at the outstanding balance on your mortgage payments, and estimate what your house is worth to get a sense of your loan-to-value ratio.
Then, you’ll need to demonstrate that you’re creditworthy and capable of paying back the loan. Usually, lenders require a minimum credit score of 620 (the higher your score, the better your chances are for loan approval, and at a lower interest rate), a debt-to-income ratio of 43% or lower, and proof of your income, among other types of financial documentation. You will likely need to pay for a new home appraisal for an accurate and up-to-date assessment of your home’s current market value.
And before you apply for a home equity loan or a HELOC, make sure you shop around to compare your options. You don’t have to use the same lender as your first mortgage, either. You’ll want to estimate potential closing costs and read the fine print that spells out the terms and conditions to make sure you work with a lender that won’t nickel and dime you with fees (a common rule with HELOCs is maintaining it for at least 36 months to avoid any closing costs).
The bottom line
A home equity loan can help you consolidate and pay off debt at a lower interest rate, but you have to weigh the pros and cons of using your home as collateral to secure a loan. It’s the roof over your head, after all, so you don’t want to take any unnecessary risks. As long as you make on-time payments and continue to pay down your debt, home equity loans can be cost-effective ways to unlock your home’s value.
