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Many households carry significant levels of debt between their mortgages, personal loans, credit card balances, student loans, and more. In fact, the average American has $90,460 worth of debt, leading many to wonder if they can tap into their assets with a home equity loan for debt consolidation.
If you’ve built up equity in your home, you might consider accessing these funds in order to consolidate your debt and begin paying it down faster. This can not only simplify your payments but also lock in a potentially lower interest rate than you’re paying elsewhere, saving you money over time.
But just because home equity loans or lines of credit are available to you doesn’t necessarily mean they are always the right choice. Here’s a look at what home equity loans and HELOCs are, how you can use them for debt consolidation, and how to decide if it’s the right move for you.
In this guide:
- Why you should consider a home equity loan or line of credit to consolidate
- Benefits and downsides of using a home equity loan to consolidate debt
- What types of debt can be consolidated with a home equity loan?
- Will the amount of debt that I have impact my ability to take out a loan?
- Will a home equity loan cover the total amount of debt?
- Should I use a home equity loan to consolidate debt?
- Are there other ways to consolidate debt?
Why you should consider a home equity loan or line of credit to consolidate debt
The average homeowner in the U.S. has about $185,000 in home equity. Equity represents the difference between their home’s current value and the remaining balance on their mortgage. That equity is considered an asset, but is often untouched until the homeowner sells their property.
Rather than letting your home equity sit untapped for years, you can use that money for home improvements, to cover big expenses, or to consolidate and repay other types of debt. This is most easily done with the help of a home equity loan or home equity line of credit, also known as a HELOC.
There are many benefits to using your home’s equity to consolidate debt, which we’ll dive into in just a moment. These benefits can potentially include:
- Reduced interest rates
- Fewer debt balances to juggle
- Overall interest savings
- Lower monthly payments
Since home equity loans and lines of credit are secured by the value of your home, interest rates are often lower than other types of unsecured debt such as credit cards or personal loans. While secured debt can often be easier to obtain and more affordable, there are some added risks to consider.
Benefits and downsides of using a home equity loan to consolidate debt
As with any other financial product, you can expect both advantages and disadvantages to taking out a home equity loan or HELOC to consolidate your debt. Here are a few of the biggest benefits to consider and downsides to note.
Pro: Streamlined payments
Recent data shows that the average American adult owns about four credit card accounts. Combine that with other types of consumer debt—such as personal loans, auto loans, charge cards, lines of credit, and more—and it’s easy to see how debt repayment can get confusing.
Rather than make five different payments each month to five different creditors on five different due dates, a home equity loan or line of credit can combine them all into one.
By using a home equity loan or HELOC, you can pay off multiple balances and clear a number of debts. You’ll then only need to worry about repaying your one home equity loan on its one due date.
Pro: Lower interest payments
Interest is how creditors and lenders primarily make money on the financial products you choose. This interest, though, not only takes more money out of your pocket, but can even keep you from paying off your debts sooner.
Unsecured debt, like personal loans and credit cards, is not backed by collateral and usually has higher interest rates. That costs you more in overall finance charges. Every penny you spend on interest is a penny you can’t dedicate to lowering your balance and extends your overall repayment effort.
Home equity loans and HELOCs are secured by an asset: your home. For this reason, home equity lenders may offer you lower interest rates. This can effectively lower the rate you’ll pay on your total debt, saving you money and allowing you to pay off other balances faster.
Con: Possible home foreclosure
Of course, there is a definite downside to backing a loan with your home: if you don’t manage your loan properly, you could lose your home.
If you default on an unsecured personal loan, you’ll probably wreck your credit and may have a judgment filed against you. If you default on a loan with your home as collateral, you’ll still hurt your credit… but now, the lender can also seize your house through foreclosure to satisfy the debt.
You could be putting your family’s home at risk by using it to secure a debt.
Con: Becoming underwater on your loan
After the housing boom of the last few years, home prices are sky-high and home equity balances are greater than ever. But what happens if home values decrease in the years to come, especially after you’ve already taken out a home equity loan?
Once you’ve used your home’s equity to secure a loan or line of credit, you remove that equity from your assets column. If you need to sell your home, you could even find yourself underwater—or owing more than the property is worth—as a result.
In a negative equity situation, you would need to pay your lender the difference out of your own pocket or could even wind up unable to sell the home entirely.
What types of debt can be consolidated with a home equity loan?
Home equity loans and HELOCs are secured products and generally have no restrictions around how the funds can be used. Borrowers can utilize that cash for pretty much any purpose, such as consolidating various types of debt.
Some common types of debt that can be consolidated with a home equity loan include:
- Credit card balances
- Personal loans
- Auto loans
- Student loans
Your home equity consolidation options are really just limited to the type of debt you have and how much you’re able to borrow against your home.
Will the amount of debt that I have impact my ability to take out a home equity loan?
There are many different factors that go into determining whether or not you can take out a home equity loan.
First, you’ll need to have home equity in order to borrow against your home’s equity. Second, lenders still want you to qualify for this new loan, which means meeting certain income and personal requirements.
The amount of debt you currently have will determine your debt-to-income ratio (DTI), which compares the minimum payment on all outstanding debt with your gross monthly income. Typically, lenders look for a maximum DTI of 45% to approve a new home equity loan, although there are some exceptions.
In addition to your DTI, lenders will look at
- the total equity you have in your house
- how much you’re trying to borrow with your home equity loan or HELOC
- your income
- your credit score
Depending on these, you may be limited in how much you can receive with a home equity loan.
Will a home equity loan cover the total amount of debt?
Whether or not a home equity loan can completely satisfy your debts depends on the amount you’re trying to consolidate and the amount of equity in your home.
Lenders won’t let you borrow 100% of your home’s equity. Instead, eligible borrowers are allowed to take out up to a certain percentage of the home’s value, often 85%.
The loan-to-value (LTV), represents the amount you owe on the home compared to its current market value. The combined loan-to-value (CLTV) includes all loans against the property, including a home equity loan or HELOC.
LTV and CLTV examples:
- If you have a home that’s worth $400,000 and you owe $260,000 to your mortgage lender, you have $140,000 in equity. This equates to a 65% LTV. [260,000 / 400,000 = 0.65 x 100 = 65%]
- If you have a $260,000 mortgage loan balance and take out an $80,000 home equity loan, you owe $340,000 total against the property. With a current market value of $400,000, this leaves your CLTV ratio at 85%. [ (260,000 + 80,000) / 400,000 = 0.85 x 100 = 85%]
Depending on how much equity you have in your property, you may or may not be able to receive enough to cover the total amount of your other debts.
If your home’s value is $350,000 and your loan balance is $250,000, you have $100,000 in equity. If your lender’s CLTV limit is 85%, your balance can go up to $297,500. This means you could borrow up to an additional $47,500 for debt consolidation.
Should I use a home equity loan to consolidate debt?
The choice to consolidate debt with a home equity loan is a very personal one. On one hand, it can be a great way to simplify debt repayment and often lower overall interest rates. On the other hand, home equity loans and HELOCs could put your house at risk of foreclosure.
These secured loans can be attractive with lower rates and streamlined terms. However, you should consider all the pros and cons of a home equity loan or HELOC to consolidate debt before pursuing this route. Other avenues of debt consolidation could be less risky and might be worth considering.
As a borrower, you will also want to evaluate how you wound up with high-interest debt to begin with. Taking a hard look at your habits and how you got into debt can help you avoid being in the same situation again a few months or years down the road.
How to consolidate debt with a home equity loan
Home equity loans are lump sum installment loans, which are disbursed all at once against your home’s equity. To take out one of these loans—and use the funds to consolidate other debt—here’s what you’ll need to do.
- Determine how much equity you have. Figure out your home equity by subtracting your home mortgage balance (and any other debt you may have against your home) from the property’s current market value.
- Consider your credit score. The higher your credit score, the better your chances of getting approved and being offered a lower interest rate. You may be able to get pre-approved through some lenders, as well, which can give you an idea of your loan options without affecting your credit.
- Compare your options. Now’s the time to compare lenders based on the loan offers and quotes they provided when you applied or requested a pre-approval. Be sure to consider all costs involved with the home equity loan, including closing costs, loan fees, and interest rates.
- Choose your lender. Once you know which lender has the best loan terms, it’s time to prepare and submit your application. Your lender will begin an underwriting process where they will consider your current income, overall debt, credit history, and more to decide whether you qualify.
- Pay off your debt. When your home equity loan is disbursed, you can request payoff quotes from your creditors and pay them in full. In some cases, your lender will directly pay your creditors. You’ll then make one monthly payment to your home equity lender over the course of the loan.
How to consolidate debt with a HELOC
A HELOC is a home equity line of credit. Unlike a home equity loan—which gives you a one-time lump sum against your home–a HELOC gives you a line of credit that you can pull from at any time during your draw period.
If you don’t use the available line of credit, you won’t owe a monthly payment. If you do borrow against the HELOC, you’ll need to make payments each month as agreed.
Here’s how homeowners can use a HELOC to consolidate their debt:
- Calculate your home’s equity. Before you can borrow against your equity with a line of credit, you need to know how much equity you have. This number represents your home’s value minus any debts against the property, such as your mortgage loan balance.
- Consider your credit score. In many cases, you can get pre-approved from various lenders without impacting your credit or submitting a formal application. A higher score often generates better interest rates.
- Compare lenders. Compare the HELOC offers you receive, including the amount you can borrow, the draw terms, closing costs, fees, and the interest rates. HELOC interest rates are variable, which means that they can change over time.
- Pick your lender and apply. Once you know which lender will give you the line of credit you need at the right price, it’s time to apply. Gather the necessary documentation (W-2, pay stubs, bank statements, and more) to show that you meet the lender’s income, debt, and other requirements.
- Begin drawing against the line of credit. A HELOC is an open-ended, revolving credit account, similar to a credit card. You can draw from those funds as needed to pay off different debts. Once you borrow against the HELOC, you’ll need to make payments until the debt is satisfied.
Are there other ways to consolidate debt?
Home equity loans aren’t the only way for consumers to consolidate their debt. Here are some alternatives to consider if you don’t have enough home equity or simply don’t want to risk your family’s property.
Whether you use a home equity loan to consolidate your debt or opt for one of the following options instead, you should do research to determine if you’ll save money and whether you’ll qualify for the product. This will make you aware of the risks and benefits that accompany each choice.
Home equity loan vs. personal loan
A personal loan is an unsecured loan offered by banks, credit unions and online lenders. There is no collateral backing this type of loan, so you aren’t directly risking any specific assets in the process. However, lenders see these types of loans are more risky than home equity loans.
With a personal loan, you can often borrow up to $100,000 in one lump sum, which can then be used to pay off one or more other debt balances. You’ll then repay the personal loan as agreed with monthly installments.
Interest rates on personal loans are usually higher than home equity loan rates, since they are unsecured. However, personal loan rates are usually lower than credit card rates, so if you are looking to consolidate credit card debt (or other high-interest balances), this could be the right choice.
Home equity loan vs. balance transfer credit cards
Some credit cards offer 0% balance transfers to new and existing cardholders. With these offers, you can pay off existing debts—whether another credit card balance, an auto loan, a personal loan, or even a student loan—up to the credit limit. No new interest will be charged for a certain period.
With a 0% interest offer, you can save money and speed your debt repayment. There is often a small fee involved (usually between 3% and 5% of the transferred amount), though this may be significantly less than you would have paid in interest if you’d left that balance with the original lender.
Balance transfer offers are often used to attract new customers. Some card issuers offer them to existing customers. In some cases, it can be worth opening a brand new credit card account just to take advantage of the right offer.
It’s important to note that balance transfer cards are most beneficial when the cardholder pays off the balance before the introductory period ends. At the end of that promotional period, standard interest charges will apply to any remaining balance and can add up very quickly.
Author: Stephanie Colestock