Are you drowning in a sea of debt? If your monthly debt payments are out of control and your budget is stretched thin, you may be considering a home equity loan to get much-needed relief. But is it a smart financial move, or should you consider other options?
Read on to learn about the benefits and drawbacks of using this approach to eliminating those pesky debt balances and how to proceed if you decide this option is right for you.
What is a Home Equity Loan?
A home equity loan is a type of debt product that lets you borrow against the equity in your home. It acts as a second mortgage and uses your property as collateral.
How Does a Home Equity Loan Work?
Most lenders let you borrow up to 85% of your home’s value through a home equity loan. This means if your home is worth $325,000 and you owe $170,000, you could access a home equity loan of up to $90,000 ($325,000 * .85 minus $170,000).
In this case, you’d receive a disbursement of $90,000 when the loan closes, payable in monthly installments over a set period. Most home equity loans come with terms of 5 to 30 years. And interest rates are typically fixed, giving you predictable monthly loan payments.
Can You Use a Home Equity Loan to Pay Off Debt?
Yes, you can use a home equity loan to pay off debt. Many homeowners leverage this option to consolidate high-interest debt, as home equity loans often have lower interest rates compared to what they’re currently paying for credit cards or personal loans.
What are the Pros and Cons of Using a Home Equity Loan to Pay Off Debt?
There are several benefits to eliminating debt balances with a home equity loan.
Lower Interest Rates Compared to Credit Cards
Credit cards come with exorbitant interest rates that drive up borrowing costs over time. The minimum monthly payments only place a small dent in the principal balance, especially if you’re near the credit limit.
However, home equity loans generally come with far lower rates, as they are secured by your home, and the lender has recourse if you default on the loan. If you’re able to qualify for a competitive rate on a home equity loan, you could save a bundle in interest by using the loan proceeds to consolidate credit card debt.
Consolidation of Multiple Debts
Instead of juggling several debt payments each month, you could consolidate using a home equity loan. Doing so could help you minimize interest costs if you’re able to secure a much lower rate. And you’ll get a single set monthly payment to work into your spending plan.
Fixed Monthly Payments
Credit cards and lines of credit come with variable interest rates that can fluctuate over time. This means you’ll also get unpredictable monthly payments that can be challenging to manage. However, fixed interest rates on home equity loans equate to equal monthly installment payments, which could also make this repayment option more viable.
Risks and Considerations
Unfortunately, there are also drawbacks to consider before deciding whether to use a home equity loan to pay off debt.
Risk of Losing Your Home
As previously stated, home equity loans act as second mortgages and use your home as collateral. So, if you default on the monthly loan payments, you could lose your home to foreclosure.
Fees and Closing Costs
Home equity loans also come with closing costs, which may include appraisal fees, application fees and attorney fees, among others. And in some instances, the costs associated with taking out a home equity loan could outweigh the benefits of lower interest rates and streamlining your monthly debt payments.
Changes in Property Value
There’s also the risk of becoming “underwater” on your mortgage if market conditions change. This happens when you owe more on your home than it’s worth. Remember, home equity loans also attach to your home, so if you end up in this situation, it can be challenging to sell or refinance your home in the future.
Are There Any Eligibility Requirements to Qualify for a Home Equity Loan?
Lenders set their own eligibility guidelines for home equity loans. That said, there are some general requirements to be aware of before moving forward with the application process.
Home Equity
Most lenders want you to have at least 15% to 20% in home equity before considering you for a loan. Again, this is the amount of the home you own outright or the difference between your property value and outstanding mortgage balance.
An appraisal is typically required by the lender to determine the property value. Remember, the more equity you have in your home, the higher your potential borrowing power.
Credit Score Requirements
A higher credit score is a major plus if you’re seeking a home equity loan with competitive terms. That said, a score of just 620 could be enough to get approved by some lenders.
Lenders also assess your debt-to-income (DTI) ratio, which is the percentage of gross monthly income used to cover debt obligations. Ideally, this number should be below 43%, although you could qualify with a higher score if there are other compensating factors.
Necessary Documentation
When you apply, prepare to provide the lender with financial and identifying documentation. This often includes proof of income, such as recent pay stubs, W-2 forms, tax returns and bank statements. The lender will also want a copy of your driver’s license or passport.
You’ll also need to provide details about your current mortgage. Proof of homeowner insurance and property title may also be required.
How to Apply for a Home Equity Loan
If you’re ready to apply, here’s how to move forward:
- Step 1: Check your home equity.
- Step 2: Gather the required documentation.
- Step 3: Research and compare lenders.
- Step 4: Formally apply for a home equity loan.
- Step 5: Await the results of the home appraisal.
- Step 6: Receive the loan approval.
- Step 7: Review and sign the loan documents.
Strategies for Using Home Equity Loans Effectively to Pay Off Debt
Once you receive the funds from your home equity loan, here’s how to strategically use them to eliminate your debts.
Assessing Your Financial Situation
Begin by computing the total amount of debt you’re looking to consolidate. Be sure to list the balances for credit card debt, personal loans, lines of credit, and any other installment loans you want to include when consolidating your debt.
Also, consider your home equity and run the numbers to determine if you have enough to cover your debts. In case you need a refresher, home equity is the difference between the amount you owe on your mortgage and the current value of your home.
Don’t forget to review your credit score. Most lenders require at least a fair credit score for loan approval. However, a good or excellent score generally means more favorable loan terms and lower borrowing costs.
Creating a Repayment Plan
Take a look at your budget and calculate how much wiggle room you have for a new monthly payment. You can subtract the payments for the debt you plan to consolidate to get a more realistic figure, but you want to leave space for disposable income and savings.
It’s also worth enrolling in automatic payments to make managing your home equity loan easier. You won’t have to worry about missing a payment, incurring late payment penalties or dinging your credit score.
Avoiding Accumulation of New Debt
If you choose to consolidate debt with a home equity loan, it’s vital that you avoid taking on new debt. You should also steer clear of your current credit cards, as using them will leave you with a bigger mountain of debt than you previously had.
Is It Smart to Use Home Equity Loan to Pay Off Debt?
Using a home equity loan to consolidate debt could be a smart financial move. You’ll get a single monthly payment and a potentially lower interest rate than your current payment. That said, you may want to explore other alternatives if you’re not disciplined enough to avoid using your paid-off credit cards or taking on additional debt. Most importantly, it’s vital to stay on top of your payments to protect your home from foreclosure.
