Tapping the equity you hold in your home can be a great way to pay for major renovations, college tuition, and other big expenses, but did you know you can also use a home equity loan for debt consolidation? We take a look at the pros and cons of using your home equity to help pay down your high-interest debt.
USING A HOME EQUITY LOAN FOR DEBT CONSOLIDATION
Your home is your biggest investment. Over time, the equity you build as you pay off your mortgage becomes a growing source of wealth. That said, the first few years of being a homeowner can be tough, especially if you are also struggling to pay off credit cards and keep up with bills while starting and raising a family.
A home equity loan allows you to tap the equity you have already built up in your home. While most often used to fund home renovations or pay for long-term investments like college tuition, a home equity loan can also be used to consolidate your high-interest debt into a single low-interest payment.
Let’s look at how using a home equity loan for debt consolidation works as well as some of the benefits and potential disadvantages of doing so.
WHAT IS A HOME EQUITY LOAN?
A home equity loan allows a homeowner to borrow money against the equity you hold in your home. Sometimes called a second mortgage, a home equity loan is secured by the value of your home itself and provides a lump sum payout and fixed rate repayments that you make over time along with your regular mortgage payments.
HOW DOES IT WORK?
Equity is the difference between what you still owe on your home mortgage and the current value of your home. If you have been making regular mortgage payments and the market value of your home has increased, you could already hold a significant equity stake in your home.
You can usually apply for a home equity loan once you have paid off at least 15-20% of the value of your mortgage and most lenders will allow you to borrow between 75-80% of the value of your equity. This is known as the loan-to-value ratio of your loan.
Home equity loans provide a substantial lump sum payout that can be used for anything you wish and you can pay it off over up to 30 years.
WHAT IS DEBT CONSOLIDATION?
Debt consolidation involves taking out a single loan, usually at a significantly lower rate or with better terms, to pay off two or more other high-interest debts. Debt consolidation is a proven way to manage out-of-control borrowing when used along with strict budgeting and a firm commitment not to take on more debt.
USING A HOME LOAN FOR DEBT CONSOLIDATION
Ideally, money borrowed against your home should go towards improvements or upgrades that will directly increase the value of the asset you are borrowing against. Many people, however, use home equity loans to afford other things that have long-term value to them, including paying for a child to attend college or to cover the costs of a major medical treatment.
Using a home loan to consolidate debt makes sense if you are struggling to pay off credit card debt, bills, or even personal loans. Replacing several high-interest payments a month with a single payment on a long-term, low-interest loan saves you money in the end while freeing you up to invest your cash in things that matter to you today.
PROS OF USING A HOME LOAN FOR DEBT CONSOLIDATION
Let’s take a look at the specific benefits that using a home equity loan to consolidate debt can bring. These include:
LOWER INTEREST RATES
As a secured loan, home equity loan rates are far lower than the rates charged on credit card balances or overdue bills. They are also significantly lower than typical rates on the personal loans that many people use when they consolidate debt. Your total interest payments will likely be significantly lower, even over a 25 to 30 year loan.
LOWER MONTHLY PAYMENTS
You will also pay less each month towards a home equity loan than you would by trying to keep up with payments on revolving debt like credit cards or store accounts. You will also make only one payment a month, rather than juggling cash to meet several different card payment deadlines.
PREDICTABLE PAYMENTS
In advance, you’ll know how much you will pay each month for years to come, allowing you to plan far into the future. You’ll even have the certainty of knowing how much you will pay in total interest payments ahead of time.
IMPROVED CREDIT
High balances, missed payments, and constant credit applications can wreak havoc on your credit score if you are juggling multiple debts. Consolidating debt lets you build your credit over time with steady on-time payments so you will pay less when you borrow money in the future.
QUALIFYING IS EASY
At the same time, if your credit is already damaged by excessive debt, choosing to secure your debt consolidation against your home might be easier than trying to roll it into an unsecured personal loan.
POSSIBLE TAX DEDUCTIONS
You might qualify for continued tax deductibility of some interest payments if you use a home equity loan to consolidate loans that were made specifically for home improvements, such as for a heat pump, new roof, or windows. Check with a tax professional to see if this would apply in your case.
CONS OF USING A HOME LOAN FOR DEBT CONSOLIDATION
At the same time, dipping into the long-term value of your home to pay off short-term debts does come with some serious potential implications. These include:
HIGHER COSTS
Home equity loans include many of the same costs you incurred when you took out your original mortgage including origination, title search, and appraisal fees as well as closing costs that can often total 2-6% of the total loan amount. Depending on the extent of your debts, the upfront cost of a home equity loan might not make it worth your while to consolidate your debts this way.
REDUCED EQUITY
Tapping the long-term value of your equity to pay off short-term debt means you will have less equity to dip into down the road for home improvement projects or college tuition. It will take you some time to build up more equity that you can borrow against in the future.
LESS TAX AND EQUITY EFFICIENT
While it might be possible to roll some tax savings into your loan, using home equity to pay for debt consolidation is less efficient than if it is used directly for home improvements or upgrades. Spending the money on improvements is the fastest way to rebuild equity because it increases the value of your home.
RISK OF TAKING ON MORE DEBT
One of the biggest risks of rolling debt into a lower-interest, long-term loan is that you will essentially “forget” about it and simply accumulate more high-interest debt. Debt consolidation only works when it is part of a long-term commitment to control and manage both your spending and your future borrowing.
RISK OF GOING UNDERWATER
Borrowing against the equity in your home also increases the risk of “going underwater” on your mortgage. This means that if the value of your property were to drop, you could end up owing more on a mortgage than your home is worth. If you were forced to sell your home before the property could recover its value, you would take a financial loss.
RISK OF LOSING YOUR HOME
By choosing to secure a second loan against your home, you are increasing the risk that you could lose your home if you fall behind or default on payments on either your home equity loan or mortgage.
ALTERNATIVES TO HOME EQUITY LOANS
When it comes to debt consolidation, there are several alternatives to using a home equity loan to pay off your other loans. Common options include:
BALANCE TRANSFER CREDIT CARDS
If you are carrying balances on two or more cards, you can lower your monthly payments by transferring the balances to a new lower-interest card. That said, interest rates remain high and your balance will continue to add up fast if you do not make more than the minimum monthly payments.
PERSONAL LOANS
Taking out a secured or unsecured personal loan to pay off high-interest borrowing provides much of the predictability and interest savings that using a home equity loan does, but you will still pay a higher interest rate unless you have a significant asset to use as collateral.
CASH-OUT REFINANCING
If you have very significant debts, a cash-out refinancing of your home allows you to access your available equity as cash, but with significant loan costs. You might also have to pay more in monthly payments on your new home, depending on market rates and your home’s value.
WASATCH PEAKS: YOUR HOME EQUITY LOAN PARTNER
Getting control of debt can be tough. If you’re ready to start a family or a new business venture but are still hobbled by having to repay high-interest borrowing, leveraging a home equity loan for cash to consolidate your debts can provide a clear and predictable way forward.
At Wasatch Peaks, we’ve been helping families put down roots in our community for decades. Talk to us today about whether a home equity loan is the right debt consolidation solution for you. We offer our members home equity loans with:
- Low-interest rates
- Flexible terms and payments lengths
- High loan-to-value ratios
- Our trademark professional and helpful member service
Talk to us about a home equity loan today or click below to find out more.
