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Debt consolidation is when you combine several outstanding debts into one, larger debt with a lower interest rate.
Consumers burdened with various forms of debt, especially high interest rate credit card debt, may feel like they struggle to pay down their debt or never really make any progress.
Debt consolidation can be a tool for consumers to pay off debt. Using home equity to secure financing can be particularly helpful for consumers because they can access a large line of credit at a low interest rate.
But is it the best choice? Here’s what to consider.
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Home Equity Loans for Debt Consolidation
A home equity loan provides borrowers with a lump sum at closing that the borrower repays in fixed amounts over a period of 10 to 15 years. Since the home serves as collateral for the loan, lenders charge a much lower interest rate than they would on other unsecured forms of debt.
Borrowers can use the proceeds from the loan to pay off their other debt obligations and benefit from the interest savings each month. Using a home equity loan for debt consolidation might also improve the borrower’s credit score by reducing the amount of the revolving credit card balance.
Some lenders do charge closing costs on home equity loans, but many lenders will waive the closing costs for their customers. Borrowers should research their options before taking out a home equity loan.
You also face an additional risk if you experience financial hardship and have trouble making the payments on your home equity loan. Since your home serves as the collateral for the loan, the lender could foreclose on your home to meet your debt obligation.
Home Equity Line of Credit for Debt Consolidation
A home equity line of credit (HELOC) is a source of revolving debt similar to a credit card and, like most financial products, has its pros and cons. Borrowers have access to a specified amount of credit that they can use, pay off, and then use again. Unlike credit cards, however, a HELOC has low interest rates because the borrower’s home acts as collateral for the line of credit.
That can help borrowers can pay off high-interest debts with the proceeds from the HELOC much more quickly than they would have without the debt consolidation. They can continue to repeat this process with other, higher-interest debt obligations over time.
As borrowers start to pay off their higher interest rate debt obligations, they will have more money available each month to put to work paying down debt. So, borrowers who use a HELOC for debt consolidation may be able to accelerate their debt repayment over time.
The cons of using a HELOC for debt consolidation are the costs and risks. The closing costs associated with a HELOC can vary greatly among lenders. Some lenders charge closing costs, others do not. Borrowers should weigh the short-term cost of obtaining the HELOC with the potential interest savings they will realize through debt consolidation.
In addition, there are risks associated with your home serving as the collateral for a line of credit. If you experience financial hardship and have trouble making the payments on your line of credit, the lender could foreclose on your home.
Alternatives to Using Home Equity for Debt Consolidation
Personal loans and 0% introductory rate credit cards are also popular options that consumers use for debt consolidation. Lenders provide personal loans for a specific dollar amount and maturity. The interest rates are higher than secured loans like the home equity loan, but they are usually lower than the interest rates on most credit cards.
Many consumers also take advantage of credit cards with 0% introductory financing by transferring existing credit card debts to these cards. The low interest rates, however, are only available for a short period of time. Then, you need to move your balance to another card or pay the high interest rates again.
Traps to Avoid
Debt consolidation is also a thriving business area for scam artists. These so-called debt consolidation companies prey on desperate consumers. Watch out for any offer that suggests you have been pre-approved or asks for any sort of payment or fee prior to loan approval.
You should also beware of any company that suggests that debt consolidation is a quick fix to your financial difficulties. Don’t give a debt consolidation company access to your bank account or sign over any title or legal authority to them. Do your research online about a company before signing any type of loan agreement.
Author: Kimberly Goodwin, PhD