Using Your Home Equity Loan or Line of Credit to Pay Off Debt
Home equity loans and lines of credit can give indebted and retired homeowners the money they need to renovate, refurbish, pay for a child’s education or go on vacation. But they can also be used to pay off credit card debt, loans, and other crippling debts—if you own a sizable stake in your home then you have all you need to utilize this option.
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What is Home Equity?
The term “home equity” refers to the value that you have in your home, either by owning it outright or by paying off a percentage of the mortgage. You can cash-in some of this equity with a home equity loan or a HELOC. There is also something known as a cash-out refinance, which works in a similar way.
Home Equity Loan
A single lump-sum loan payment is provided and can be used to make large purchases or for debt consolidation purposes. You make a monthly payment to repay this loan, with a fixed rate of interest charged on top of this. It’s basically a fixed-rate loan leveraged against part of your home.
- Receive a lump-sum payment.
- Use the money to pay off personal loans, student loans, and credit card debt.
- Borrow with just 20% equity.
- Risk of foreclosure.
A home-equity loan is, in essence, a second mortgage and if you stop making your payments then your home may be repossessed. Your credit score will also suffer severely. The same is true for a HELOC, only with some notable differences.
Home Equity Line of Credit
A HELOC provides you with a revolving line of credit, not unlike a credit card. There are two periods. During the first, you can borrow money when you need it and all of your payments will go towards the interest. During the second period, your monthly payment will cover both the interest and the principal, and you can’t borrow any more.
- Borrow against the value in your home.
- A revolving line of credit that works like a credit card.
- You can use the money as you need it.
- Pay only the interest to begin with.
- Not as helpful if you need large sums for debt consolidation.
- Risk of foreclosure.
A HELOC uses variable rates of interest, but you have more control over the balance and can keep the interest low by keeping your balance low. Your provider will set a maximum credit limit and discuss the terms, rates, repayment period, and potential issues with you.
In simple terms, a cash-out refinance replaces your current home loan with a new one, prolonging the term by as much as 30 years and allowing you to collect the difference in cash.
- Interest rates tend to be lower.
- Initial fees may be higher.
- As with a new mortgage, closing costs will be required.
- You will receive a lump sum of money.
- Risk of foreclosure.
While home equity loans and HELOC are considered second mortgages, a cash-out refinance still utilizes the “first” position as it replaces the existing loan.
We have discussed reverse mortgages elsewhere and have gone into a lot of detail, so we won’t repeat that here. These options are still worth considering though as they can give you the money you need to repay credit card debt and loans.
- You need to be at least 62 to apply.
- You need to own at least 50% of the house.
- There are many terms and rules to follow.
- You can borrow a large sum of money.
A reverse mortgage works similarly to home equity loans, only the eligibility criteria is stricter, and the borrower doesn’t need to repay the balance until they sell, move out or die. With a reserve mortgage, you’re basically selling a share of your house that won’t be cashed until a later date, allowing you to borrow that money now and repay it later.
Pros and Cons of Tapping Home Equity to Pay off Debt
HELOC and home equity loans always tend to sound a lot better than they actually are. The commercials make them seem easy, harmless—a reward for meeting all those mortgage payments and an easy way to clear other unsecured debts. But while there are some huge benefits to these options, there are also some potential pitfalls to be wary of.
What are the Advantages of Using Home Equity to Pay off Debt?
There are many benefits to using home equity loans to pay your debts, including:
You Will Pay Less Interest
Home equity loans and HELOC provide lower interest rates, while equity loans also come with fixed interest rates. As discussed before, debt consolidation loans can be expensive over the long-haul, because while you may get a better APR and a lower monthly payment, this is offset by an extended-term that greatly increases your total debt. Home equity loans can reduce your monthly payments and interest rate without prolonging the term.
Once you use this loan to clear your credit card debt, student loans, and personal loans, you’ll essentially swap multiple high-interest-rate debts for one low-interest-rate debt, making everything cheaper and more manageable.
You are Paid in Cash
One of the issues with debt consolidation is that it’s conducted on your behalf by debt management companies, debt consolidation companies, and credit card companies (in the case of balance transfer credit cards). You don’t see the money, you don’t clear the debts yourself, and there’s nothing left over at the end to cover additional expenses and fees.
With a home equity loan, the money is yours to do with as you please. Theoretically, not only can you clear your debts, but you can negotiate and settle them, reducing your expenses and ensuring you have more money in your pocket at the end of the day. Anything you have leftover can be placed in a savings account, ready to cover your next monthly payment or prepare for an emergency.
It’s Easier to Get Higher Limits
Your options are pretty limited when it comes to debt consolidation loans and refinancing. You either need a great credit score to get a loan large enough to cover your debts, or you need to make sacrifices elsewhere. With a home equity loan, it’s easier to borrow large sums of money as everything is secured against your home and lenders are more willing to lend.
What are the Disadvantages of Using Home Equity to Pay off Debt?
For every positive there is a negative, consider both before using home equity loans to clear your debts:
It Doesn’t Fix the Root of the Problem
Debt can be caused by bad luck and circumstances out of your control. If you’re ill, for instance, then you may struggle to work, in which case you’ll need increasing amounts of credit card debt to cover life’s essentials, all while your medical bills grow out of control. However, many borrowers fall into a cycle of persistent debt because they make bad decisions, don’t budget properly, and struggle to keep their finances in check.
Debt management and even bankruptcy can fix the problem while teaching you how to control your finances, but a home equity loan will simply provide a quick fix without addressing any underlying issues. That debt may return, and this time failing to meet payments will put your house at risk.
You Could Lose Your House
If you fail to make payments on a credit card debt then your credit score will suffer, and you may be hassled into a settlement by a collection agency. Some collectors will sue you and seek a judgment, but most will simply give up, understanding that their hands are pretty much tied.
With a home equity loan, it’s a different story. Your credit score will take a hit initially and if you fail to make payments then the lender may repossess your asset, which means you could lose your home.
With home equity loans, you can’t simply wait for the statute of limitations to pass or hope that everything will blow over.
Types of Home Equity Loans for Debt Consolidation
We discussed some of the options for home equity loans above, but let’s take a closer look and answer some commonly asked questions about them.
What Types of Home Equity Loan Can be Used for Debt Consolidation?
Refinancing is a good option for debt consolidation, but home equity loans may provide you with more money for with less equity, making them ideal for this purpose. You can generally get a home equity loan with just 20% equity, but it all depends on the loan-to-value ratio (LTV), which compares the value of the loan to the value of the asset.
The lender will also consider your credit score and debt-to-income ratio to determine your creditworthiness. A lender will typically look for a credit score of 620 or more and a debt to income ratio of at least 43%, although it all depends on the lender.
As an example, let’s imagine that your house is currently worth $200,000 and you have a $100,000 balance remaining. This gives you an LTV ratio of 50%. If you have a balance of $160,000 on an asset of $200,000, then your equity is just 20%, your LTV ratio is 80%, and you’re on the very cusp of what a lender will accept.
What Happens if you Don’t Make Payments?
A home equity loan is a secured loan, which means it’s backed by collateral. This decreases the risk for the provider and makes you a more viable customer, because they know that if anything happens and you stop meeting your obligations, they can simply take your house.
This is not a process that a lender will rush into as foreclosures are expensive and time-consuming, but a lender stands to gain a lot more from a secured debt repossession than they do from selling an unsecured debt to collection agencies.
If you fail to meet those monthly payments, your credit score will suffer and you may lose your home.
How to Pay off Debt with a HELOC
Paying off debt with a HELOC can save you a small fortune in interest payments, especially if that debt is tied to credit cards and high-interest personal loans. The average credit card debt in the United States is between 17% and 19%, with some cards going as high as 26%. The average HELOC is just 6% and it’s possible to get a much lower rate.
You’re also swapping multiple monthly payments for a single manageable payment, which makes your job much easier and reduces the risk of missed payments, penalties, and fees. The only downside of all this, and it’s a pretty big one, is that your home is secured against the debt.
If you default on multiple unsecured debts your credit score will suffer and you may struggle to get a loan or credit card for a few years, but you probably won’t lose any assets. Default on a HELOC and you could lose your home.
Can You Pay off a Mortgage with a HELOC?
A home equity line of credit is designed to give you money when you need it and its purpose isn’t to clear your mortgage. However, there are people who are using it for that purpose. We wouldn’t recommend it, but if you want to try this for yourself this is what the process typically looks like:
- Make sure your income exceeds your outgoings. You will need a positive cash flow—the higher, the better. This is key and if you don’t have a positive cash flow right now then you’ll need to work on it before beginning.
- Acquire a credit card that has a long grace period, which means you can accumulate credit card debt without worrying about the interest straight away.
- Put your first paycheck towards your mortgage and use your new credit card to cover additional expenses.
- Before the grace period ends, add a home equity line of credit to your home.
- Transfer the balance of your credit card to the HELOC.
- Repay the HELOC with your next paycheck.
To give you an idea of how this might work, imagine that you have a $100,000 balance, a $1,000 mortgage payment and an income of $5,000. In the first month, you put the full $5,000 towards your mortgage and use a credit card to cover other expenses such as food, clothing, and utility bills. For the sake of simplicity, let’s assume this comes to $1,000.
You pay your mortgage and credit card debt using the HELOC, which means you now have $2,000 on the HELOC. In the second month, you use your paycheck to clear that $2,000, pay your $1,000 expenses, and put the rest towards your mortgage, which means your HELOC will be $0 and your mortgage will be less than $94,000 (depending on the interest in each minimum payment).
If you follow this cycle closely then you’ll repay a significant percentage of your balance every single year. Not only will this drastically shorten the mortgage term, but because the balance has less interest to compound, it will also decrease the total interest that you pay, thus saving you a lot of money.
The idea is that you put as much money as possible towards the balance, while never letting your credit card balance accumulate any interest.
Why is it Smart to Pay off Debt with a Home Equity Loan?
Credit card debt can be soul destroying. It grows and grows, because every month you’re paying a huge amount of interest and a small amount of principal. Over the course of several years, you could pay upwards of $5,000 worth of interest on a debt of just $10,000. If you opt for a consolidation loan to pay off that credit card debt, the term will extend for another 5 or 10 years and while your monthly payment will drop, your total interest could increase above $10,000.
Credit card debt consolidation isn’t always favorable for the debtor, because the provider is taking a sizeable risk. Not only are they lending a lot of money that isn’t secured against an asset, but they’re lending that money to someone they know is having a hard time, someone who only came to them because they couldn’t afford to repay their debts.
With a home equity loan, it’s a different story. Your reason for getting the loan is the same, but the lender knows that if anything happens, they won’t be forced to sell the debt cheap or chase you through the courts. They can just repossess your asset and get their money back that way.
That’s why the interest rates are so favorable on a home equity loan and why it’s one of the best ways to pay off credit card debt. You’re not prolonging the term just to reduce the minimum payment; you’re not adding debt on top of debt. You’re simply swapping lots of high-interest unsecured debts for a single, low-interest secured debt. The result is a debt that charges less interest and costs you less over the term but can cause many more problems if you default.
Summary: Are These Options Right for you?
You could be mistaken for thinking of home equity loans and HELOC as easy money—a ticket to that extension you’ve always wanted or the vacation you’ve had your eye on. But while they can give you the money you need at a rate you can afford, they’re not without risk.
A home equity loan is just like any other loan and can cause just as many problems; a HELOC is like a low-interest credit card that could cost you your house. Don’t be rush to sign your name under the dotted line unless you really need that money (as with a consolidation loan), fully understand the repayment terms and requirements, and are confident you can meet your obligations.
If you’ve spent any length of time repaying your mortgage and gradually turning the bank’s property into your house, the last thing you want to do is put that equity into jeopardy.