Chances are you’ve got some high-interest non-mortgage debt that you’re dealing with. If you do, you’re not alone. In the U.S., credit card debt alone is around $860 billion. That high-interest debt can cost you a lot of money every month.
But if you’re a homeowner, there may be a solution available to you. You could take advantage of your home equity and use it to consolidate your loans and pay less each month.
One way to do this is with a home equity loan. How does that work? Read on and learn more.
Tapping Into Your Home Equity To Consolidate Debt: How It Works
Before we talk about using your home’s equity for credit card debt consolidation, it’s a good idea to understand what home equity is and how a home equity loan works.
What is home equity?
Your home equity is the difference between the amount you owe and the current appraised value of the home.
If you owe $200,000 on your mortgage and your home has been appraised at $300,000, you’d have $100,000 in home equity available.
What is a home equity loan?
A home equity loan (sometimes called a second mortgage) lets you borrow against the available equity. Essentially you take out another loan and agree to pay it back over time. Like with your mortgage, your home acts as collateral, so the lender can take possession of your home if you can’t pay them back.
When you take out a home equity loan, you receive a lump sum payment you can use however you choose. You’ll then need to pay back the loan in equal monthly payments over a fixed period of time ranging from 3 – 20 years.
A home equity loan usually has interest rates similar to a mortgage, so assuming you have good credit you can probably get a home equity loan with an interest rate of 3% – 8%.
How can you use a home equity loan to pay off your debts?
Let’s say you have $30,000 in credit card debt that you’d like to consolidate and pay off. You commit to paying off your credit card debt in 5-years and your budget will allow you to spend up to $750 a month to achieve that goal.
Here are two potential ways you could do that.
Pay down the balance on your credit card
Credit cards tend to have interest rates ranging from 15% – 25%. Let’s say you have a relatively low 15% interest rate and you decide to make regular monthly payments to pay down your $30,000 balance. You’d need to pay $713 a month every month for 5 years and would pay $12,821 in interest.
This doesn’t account for the fact that credit card rates can adjust over time and the credit cards usually charge additional fees. You’d also need to stop using your credit cards so you aren’t adding more debt.
Take out a home equity loan
Let’s say you decide to borrow $30,000 at a 6% interest rate and a 60-month (5-year) repayment term with a home equity loan. You’d need to pay $580 each month and would pay $4,799 in interest.
Notice the difference? With a home equity loan, you’d pay $133 less each month and over $8,000 less in interest. You also have the peace of mind knowing that if interest rates go up, your loan amount will stay the same.
How To Get a Home Equity Loan
Given the potential for savings, a home equity loan seems like a no-brainer. Of course, wanting a home equity loan and getting one are not quite the same.
Do you have enough equity?
The first thing to know about home equity loans is that you need enough home equity to make the loan worthwhile.
Let’s go back to our earlier example of a homeowner with $200,000 in mortgage debt on a home appraised at $300,000, leaving them with $100,000 in home equity.
Most lenders won’t let you borrow against all of the equity in your home. Instead, they’ll extend a home equity loan for up to 80% of the home’s appraised value. So if your home is appraised at $300,000, your lender might only let you borrow against $240,000 of your home’s value.
So now instead of $100,000 ($300,000 – $200,000) you’d only be able to borrow against $40,000 ($240,000 – $200,000) in home equity.
Can you cover closing costs?
Keep in mind that a home equity loan may also come with closing costs. These usually average around 2% – 5% of the amount you borrow. At the very least, you’ll probably pay around $600 – $2,000 out of pocket to cover your home appraisal.
Do you have good credit?
Beyond home equity, you’ll need most of the same things you’d need to qualify for a mortgage. Your credit score will need to be at least 620 or higher and most lenders prefer that you have a debt-to-income ratio of 43% or less.
What To Consider Before Consolidating Debt With Home Equity
Before you get a home equity loan to consolidate debt, it’s important to understand how you got into debt in the first place.
Accidents and emergencies happen and some types of debt are unavoidable. But taking out a home equity loan without a plan to manage and pay down your debt can be risky.
Do you have a plan?
Let’s say you pay down your existing debt with a home equity loan. If you continue to accumulate more debt, you could wind up back where you started. Only this time, you risk losing your home if you can’t pay back your debt.
Before taking out a home equity loan, it’s important to ask yourself some important questions:
- Do I have enough income to cover my monthly home equity loan payments even after I pay off my current debt?
- Am I taking the necessary steps to control my money, like creating and sticking with a budget?
- Am I controlling my spending and minimizing my use of credit cards and other high interest debt?
If you’re not sure of the answers to these questions, you may want to work on developing a plan. If you’re not sure where to start, talk to a financial advisor or a debt or credit counselor.
Is consolidation worth it?
Not all types of debt are right for consolidation with a home equity loan.
Federal student loans: Federal loans have relatively low interest rates already. If you consolidate your student loans and pay them off with another loan, you lose access to important options like loan forgiveness, forbearance or other income-based repayment plans.
Car loans: While your auto loan interest may be higher than the interest rate for a home equity loan, you may want to weigh your options. After all, if you lose your car you can still live in your home, but if you lose your home, it’s a lot harder to live in your car.
What are the pros and cons of consolidating debt with home equity?
Consolidating your payments with a home equity loan means you have fewer payments to worry about every month. This reduces the chances of missing a payment.
A home equity loan usually offers an interest rate ranging from 3% – 8%, while the interest on personal loans and credit cards can have interest rates ranging from 6% – 25%.
Lowering the interest you pay could allow you to pay less every month while paying off debt.
Because your home is the collateral for the loan, you risk losing your home if you default on your monthly payments.
A home equity loan is still debt. It may be easier to manage, but you’re not erasing it.
If you borrow against your home while home values are high, you risk owing more than your home is worth if values drop. This can complicate things if you need to sell your home in the future.
A home equity loan lets you stretch out your payments over a longer period of time. You’ll get lower monthly payments, but you’ll also need to make those payments consistently for a longer period of time. And, as we all know, the longer the repayment period, the more you’ll pay in interest.
Home equity loans often come with closing costs, including a lender origination fee, the fee to order a property assessment and more. On average, these can equal between 2% – 4% of loan value.
Alternative Debt Consolidation Options
Let’s say a home equity loan isn’t right for you. It’s not the end of the line – you have other options available.
Home equity line of credit (HELOC)
If you have home equity, a home equity line of credit (HELOC) could work for you. A HELOC is similar to a home equity loan. The key difference is that a home equity loan gives you a single lump sum payment, and a HELOC gives you a set amount of money you can borrow against when you need it.
A HELOC also works like a credit card – when you pay down your balance you can borrow against your available credit as much as you’d like.
If you don’t want to take out a second loan, you could consider a cash-out refinance with a new mortgage loan. Instead of borrowing just enough to cover the cost of buying the home or paying off your existing mortgage, you borrow extra money you can use as you see fit.
A cash-out refinance may offer lower interest rates (similar to a mortgage), but you may also have a more involved loan approval process.
Balance transfer credit cards
If you don’t have home equity, you may be able to get help from a balance transfer credit card. Credit card companies let you transfer balances from one card to another with an interest rate as low as 0%. But be aware that these low rates are often temporary, lasting only 6 – 18 months.
If you don’t have a large balance to pay down, taking advantage of one of these offers can help you save money while you focus on paying down your balance. But once the promotional rate ends, your interest rate could jump back to where it was before, or even higher.
Also, many of these offers require you to pay a balance transfer fee of around 1% – 5%, which gets added to your balance right away.
Many lenders offer personal loans for debt consolidation. These loans are unsecured, meaning collateral is not required and you won’t have to worry about losing your home. These loans usually have fixed interest rates and a fixed repayment term like a home equity loan.
But the interest rates tend to be higher, ranging from 6% – 15% or higher. So the amount you’d save in interest may not offer as much in savings compared to a home equity loan.
Debt management plan
If you’re behind on your debt payments and are concerned that you are in way over your head, a debt management plan or debt settlement plan may help. You negotiate these plans with your creditor to pay less than you would normally owe to settle your debt and avoid going into collections.
You can do this yourself, but you may benefit from working with a non-profit debt counselor who can walk you through the process and negotiate with your creditors on your behalf.
Finally, if you’re dealing with debt that you can’t manage, you may want to consider filing for bankruptcy. This is a big step, so you should only do this after consulting with a lawyer. While bankruptcy does have a negative impact on your credit, it’s a temporary condition and you can rebuild your credit within a few years.
Control Your Debt, Don’t Let Your Debt Control You
If you want to take control of your debt and you have enough home equity, a home equity loan can be a great way to do it, save on interest and help control your finances. And if a home equity loan isn’t the right solution, never fear, there are other ways to conquer your debt.
Federal Reserve Bank of New York. “Household Debt and Credit Report.” Retrieved April 2022 from https://www.newyorkfed.org/microeconomics/hhdc