If you’re getting hounded by debt collectors or your monthly minimums are eating up a huge chunk of your budget, consolidating your bills can give you a little more breathing room. Transferring your high interest credit card debt to a card with a lower rate or taking out a personal consolidation loan are two options to consider but homeowners also have a third choice in the form of a home equity loan. Going this route can be cost-effective in the long run but it’s not without its dangers. How does a home equity loan work? Here are some pros and cons to keep in mind if you’re planning on using your equity to eliminate debt.
A financial advisor can help you answer questions about home equity and optimize your financial plan to manage debt.
Reasons to Use Home Equity to Pay Off Debt
If you’re considering a home equity loan to pay down debt, here are three common reasons you may want to consider taking one out:
1. You’ll save on interest. Often, the number one reason people choose to consolidate their debts is because they’re tired of throwing away hundreds or even thousands of dollars a year on interest. Home equity loans typically have a much lower fixed rate and come with a set repayment period which helps to keep the amount you spend on interest to a minimum. As an added bonus, interest you pay on a home equity loan is usually tax-deductible since it’s essentially the same as taking out a second mortgage on your home.
A home equity line of credit or HELOC works a little differently in terms of the interest, since they tend to come with a variable rate. The other major difference is that with a home equity line, you’re allowed to just make payments towards the interest for a certain period of time. If you’re thinking of using a HELOC to consolidate your debt, you want to make sure you get a capped lifetime rate and make payments toward the principal to keep the costs as low as possible.
2. You’ll have fewer monthly payments. When you’re juggling multiple payments to several different creditors each month it’s easy to lose track of when things are due. If you end up paying something late, you’ll likely have to fork over a fee and there’s also a chance that your credit might take a hit. When you consolidate everything into a home equity loan, you only have one payment to worry about so there’s less of a chance of overlooking something.
3. Loan limits are higher. If you’ve got a large amount of debt you’re trying to consolidate, you may run into trouble getting a lender to approve you for a loan or trying to transfer it all to a single low interest credit card. One of the nice things about a home equity loan is that the amount you can borrow is usually much higher. Depending on the lender, you may be able to borrow as much as 85% of the value of your home, minus anything you still owe on the mortgage. If you’ve built up a lot of equity, you could use a chunk of it to pay off all your debts and still have room to borrow again if need be.
Reasons Not to Use Home Equity to Pay Off Debt
Before you take out a home equity loan, you may want to consider these two reasons to avoid one first:
1: It doesn’t necessarily solve your debt problem. A lot of people have the misconception that a home equity loan is a magic bullet for getting rid of debt but it’s really more of a band-aid than a cure. When debt is created because of something unforeseeable, like a job loss or major illness, using your home equity to keep the collectors are bay may be the best solution. On the other hand, if you’re thousands of dollars in credit card debt because you have a shopping addiction or you just never learned to budget, borrowing against your home doesn’t address the real issue and may just perpetuate the problem.
2. It puts your home equity on the line. Unsecured debts, like credit cards, aren’t tied to any specific collateral. If you don’t pay, there’s the chance that you could end up getting sued but no one is going to come in and try to seize your personal property. A home equity loan, however, is backed by your property and if you find yourself unable to make the payments, there’s the possibility that you could lose the home. If your income takes a hit and you don’t have anything in savings to cover the gap, you could find yourself out on the street if the bank decides to foreclose.
Bottom Line
A home equity loan can be a useful tool for consolidating debt but it’s not always the right choice. Before you tap your home’s equity, it’s worth it to look at every possible avenue to minimize the risks.
Financial Planning Tips
- Whether you’re looking to buy a home or pay down your debt, a financial advisor can help you create a financial plan for your needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A reverse mortgage accesses the equity you have built up in your home and converts it to cash payments to you. But before you put your home up as collateral, make sure you fully understand what you’re getting into.
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