If you’re a homeowner with too much debt, a financial product called a home equity loan can help you escape it.
While taking out a home equity loan can be risky – after all, your home is being used as collateral for the loan – the rates on the product are generally lower than on credit cards or personal loans.
“As long as you have a stable source of income and know you’ll be able to repay the loan on a timely basis, the lower fixed rates of a home equity loan make it a smart choice,” says Richard Ortoli , co-founder. of the New York law firm Ortoli Rosenstadt LLP. “However, making all of your payments on time is crucial to keep your home from being in jeopardy.”
Here is how you can determine if a home equity loan is the right choice for debt consolidation.
What is a home equity loan
Often thought of as a second mortgage, “a home equity loan is a flexible loan on your home that is usually on top of your existing mortgage,” says Alex Klingelhoeffer, wealth advisor at a national consulting firm, Exencial Wealth Advisors. Here is a hypothetical example provided by Klingelhoeffer:
- House purchased $ 250,000 in 2015
- $ 50,000 down payment.
- Five years later, in 2020, the house is now valued at $ 350,000.
- $ 180,000 mortgage balance
- In 2020, in this example, fairness in property is now $ 170,000.
- “The banks will allow you to borrow money against this value [the equity] via a home equity loan or home equity line of credit (HELOC), ”says Klingelhoeffer.
Home equity loans and HELOCs use the equity in your home to allow you to borrow money. However, HELOCs work more like credit cards. While home equity loans allow borrowers to withdraw a lump sum and then repay the loan through fixed payments at a fixed interest rate. HELOCs have variable interest rates with payments that are not fixed.
Since you are using your home as collateral for the loan, the interest rates on home equity loans are generally lower than on other types of financing, especially credit cards. However, failure to pay the fixed monthly payments on time can cause the lender to put a lien on your home and possibly go into foreclosure.
Can I use a home equity loan to consolidate debt?
Home equity loan borrowers can withdraw a lump sum and use it as they see fit. Home equity loans can be a great way to get cash up front to pay off high interest bills in one fixed payment.
The interest rates for home equity loans are generally lower than those for many high interest loans, such as credit cards. If you want to save on the difference in rates, a home equity loan can be a good option for consolidating and paying off your debt.
A home equity loan can be a good option to consolidate your debt. But since your house is at stake, you should only take out this type of loan if you are confident that you can make the payments.
The caveat is that you need to make sure that you are able to make the loan repayments. Failure to pay could mean the loss of your precious collateral – your home. Making these payments on time is essential to avoid exacerbating or creating spiraling debt, Ortoli explains. “A home equity loan should only be used for debt consolidation if you have a stable source of income and are confident that you can make all of your payments for the new loan,” Ortoli explains.
Weighing the pros and cons of a home equity loan to consolidate debt
- Interest rates are generally lower than those of other loans.
- It may be easier to qualify “since it is secured debt,” Ortoli says.
- Able to shop for the best terms and lowest interest rates among various financial institutions.
- The funds are received in a lump sum, so that borrowers can immediately pay off large debts and other expenses.
- No stipulation on the use of borrowed funds.
- The prices are generally fixed.
- Placing your home as collateral when the default could lead the lender to put a lien on your home.
- The easy-to-access loan could mean it’s too accessible for people who are not financially prepared, Ortoli says.
- If the home’s value goes down, home equity loan borrowers may end up owing more than their home’s value, leaving them in a deeper hole.
- This is a loan that is in addition to an existing mortgage.
Alternative ways of debt consolidation
“At the end of the day, consolidation is a powerful strategy, but think of it as a cure, not a cure,” says Klingelhoeffer. “The real cure is to have positive cash flow and to pay off your debt at a manageable level.” Freeing up monthly cash could also help channel funds into an emergency fund and retirement. Many experts will say that it is important to start early because it is a positive step in building wealth.
If you don’t want to risk having a lien on your home, but are looking to free up cash and consolidate debt, there are several ways you can consolidate debt.
Balance Transfer Credit Card: Some balance transfer cards offer an introductory 0% interest rate. Most range from 12 to 18 months until the APR goes into effect. Several debts can be transferred to the card. If you pay off the card balance before the introductory period ends, all of your payments will go 100% on the balance instead of the balance plus interest. This strategy can help pay off debt sooner and save on total interest. Depending on the issuer, there may be restrictions on the type of debt that can be transferred, however, when a home equity loan has no stipulation on how to use it.
Personal loan: A personal loan could be a better or a worse option depending on the APR you qualify for. If the personal loan is unsecured, it means that you will not have to use your home as collateral. And if you can get a personal loan rate that is lower than the home equity rate, it could work in your favor. Generally, you can use the personal loan funds however you want. Be careful, however, of origination fees and prepayment fees.
Debt management plan: If you have unmanageable debt and need help sorting through your options, a credible credit counseling agency can help. We recommend that you use an agency qualified by the National Foundation for Credit Counseling.
Debt Settlement Plan: Using a debt settlement service can help you in the process of negotiating your debts. However, the service is not free. Ultimately, you don’t need to pay for this service since you can contact creditors directly and ask to negotiate or settle the outstanding balances yourself.
Refinancing: Interest rates are low right now, so if you are a homeowner, you may be eligible for new great loan terms. Refinancing a 30-year mortgage can allow you to spread the loan balance over 30 years versus 10 years like with a home equity loan, says Chuck Czajka, founder of financial consulting firm Macro Money Concepts in Florida. If refinancing reduces your monthly mortgage payment, you can use the freed up cash to pay off your debt.
A cash refinance can also work by taking out a new mortgage for more than what is owed, but getting a check for the difference, to be used as desired, at closing. Refinancing the entire mortgage and taking out the equity needed to pay off debts is an option to consider, explains Czajka. Pay close attention to closing costs. Closing costs could exceed the cost of your debt.
How To Get A Home Equity Loan For Debt Consolidation
If you decide that a home equity loan is the best option for you, here’s how to get started.
- First of all, it is important to know the value of your home in order to know your equity.
- Check your credit score and take steps to increase it for a better rate.
- “You can get a home equity loan for debt consolidation by first applying to the bank that holds your mortgage,” Czajka. “This bank will likely know you and be able to help you get through the home equity loan process faster.”
- Buy and compare the best rates, terms, and fees with at least three lenders before you apply.