Homeowners have seen property values soar over the last several years. As a result, many have turned to home equity lending options to access cash and fund home renovation projects.
A home equity loan or a home equity line of credit (HELOC), also referred to as a second mortgage, can also be an effective financial tool to consolidate high-interest debt into a lower monthly payment. While home equity loan rates and HELOC rates have been rising, they still remain significantly cheaper than credit card interest rates: for example, 8.94% for home equity loans versus 20.72% for credit cards, according to CNET sister site Bankrate.
Read on to determine if a home equity loan is a wise move for your debt consolidation strategy.
Should you use your home equity to consolidate debt?
Home equity refers to the calculated percentage of your home that you own. One reason to leverage your home equity would be to pay off higher-interest consumer debt, like credit cards. If you’re struggling to keep up with different payment dates on four different bills, having one loan can simplify your finances while helping you save on interest. When you use your home’s equity to consolidate debt, you’d be paying a lower amount each month to pay off an equal amount of money.
If you take out a secured loan against your home, you need to make sure the end result will make your personal finances better, not worse. While you can use a loan or borrowed funds for whatever you want, home equity loans and HELOCs aren’t for covering the costs of your summer vacation, holiday gifts or leisure spending. You don’t want to end up even deeper in debt.
Pros and cons of using home equity to consolidate debt
Pros
Lower interest rate: Home equity loans and HELOCs tend to have lower interest rates than credit cards or personal loans, which can save you money over the course of your loan term.
One lower monthly payment: Combining all your debts into one monthly payment makes paying off your debt more manageable and should lessen the amount you pay every month.
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: If you fail to make payments or default on your loan for any reason, your bank or lender can repossess your property.
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.
Loan limits: If you have a low or less-than-stellar credit score, or you’re carrying a lot of debt, you may not have access to a very high loan amount, and the interest rate will likely be higher too.
Rising rates: As the Federal Reserve has hiked interest rates, home equity products have followed that upward trajectory.
Alternative ways to consolidate debt
Before you commit to a home equity loan or HELOC and put your house on the line, consider other types of financing. Rather than taking out a second mortgage, evaluate options such as a 0% interest credit card or a personal loan. Though they typically come with higher interest rates, they don’t come with the risk of losing your home.
Balance transfer credit cards
Some balance transfer credit cards offer a 0% interest rate for an introductory period, ranging from six to 21 months. If you have an effective strategy to eliminate 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, 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 and work with a nonprofit agency that charges little to no fees. 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 get a personal recommendation for a reputable organization.
How to apply for a home equity loan to consolidate debt
- Make sure you’ve built up enough equity in your property -- typically 20%, although some lenders will consider applicants with less.
- Check your credit score. You’ll want to demonstrate that you’re creditworthy and capable of paying back the loan. Lenders usually 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.
- Shop around to compare your options before deciding on a lender and the type of loan. Consider whether a home equity loan, which gives you a lump-sum payment with a fixed interest rate, or a HELOC, which is a revolving line of credit that typically comes with a variable interest rate, is better for your personal situation.
- Submit an application. Get your financial documentation ready, including proof of income, bank statements and more. Lenders prefer a debt-to-income ratio of 43% or lower when approving applicants’ loan applications.
- Estimate potential closing costs for a home equity loan or HELOC, including a new home appraisal for an up-to-date assessment of your property’s current value.
- Read the fine print that spells out the terms and conditions before you sign, and make sure to review all fees.
The bottom line
A home equity loan or a HELOC 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. As long as you make on-time payments and continue to pay down your debt, tapping into your home equity can be a smart financial move.
FAQs
Home equity borrowing is cheaper than a credit card, but it’s not a slam dunk. Using a home equity loan or HELOC to pay off credit card debt only works if you have enough discipline to pay down the loan principal.
If you pay off credit card debt by tapping into your home equity, but then continue to carry a balance on your credit card, you’ll end up in more debt, which cancels out the reason you took out the loan in the first place.
Home equity loan rates determine how much money you’re responsible for paying back to the bank on top of your loan principal. Currently, home equity loan and HELOC rates are around 9%, but fluctuate based on economic conditions.
The minimum credit score needed to qualify for a home equity loan is 620. However, if you have a higher credit score, you could be approved for a larger loan with lower interest rates.
