If you’re a homeowner who’s taken on too much debt, a financial product known as a home equity loan may help you escape it.
Although taking on a home equity loan can be risky — after all, your house is used as collateral for the loan — the product’s rates are typically lower than those like credit cards or personal loans.
“As long as you have a steady source of income and know that you will be able to repay the loan in a timely manner, the lower fixed rates of a home equity loan make them a sensible choice,” says Richard Ortoli, co-founder of New York City law firm Ortoli Rosenstadt LLP. “However, it is crucial to make all your payments on time to avoid your home being at risk.”
Here is how you can determine if a home equity loan is the right choice for debt consolidation.
What Is a Home Equity Loan
Often viewed as a second mortgage, “a home equity loan is a flexible loan against your house that is typically in addition to your existing mortgage,” says Alex Klingelhoeffer, wealth advisor at a national advisory firm, Exencial Wealth Advisors. Here is a hypothetical example provided by Klingelhoeffer:
- Home purchased for $250,000 in 2015
- $50,000 down payment.
- Five years later, in 2020, the house is now appraised at $350,000.
- $180,000 balance on the mortgage
- As of 2020, in this example, the equity in the property is now $170,000.
- “Banks will let you borrow money against this value [the equity] via a home equity loan or home equity line of credit (HELOC),” says Klingelhoeffer.
Both home equity loans and HELOCs utilize the equity of your home to allow you to borrow money. However, HELOCs operate more like credit cards. Whereas home equity loans allow borrowers to withdraw a lump sum then pay back the loan through fixed payments at a fixed interest rate. HELOCs have variable interest rates with payments that aren’t fixed.
Because you’re using your house as collateral for the loan, interest rates on home equity loans are typically lower than other types of financing, especially credit cards. However, failure to pay fixed monthly payments on time can result in the lender putting a lien on your home and eventually foreclosure.
Can I Use a Home Equity Loan to Consolidate Debt?
Home equity loan borrowers can withdraw a lump sum and use it as they wish. Home equity loans can be an excellent way to get money up front to pay off high-interest bills in one fixed payment.
Home equity loan interest rates are typically lower than many high-interest loans, such as credit cards. If you stand to save on the rate difference, then a home equity loan can be a good option to consolidate and pay off debts.
A home equity loan may be a good option to consolidate your debt. But since your home is at stake, you should only take on this type of loan if you’re sure you can make the payments.
The caveat is that you need to make sure you’re able to make the loan payments. Defaulting on payments could mean losing your precious collateral — your home. It’s critical to make those payments on time to avoid exacerbating or create spiraling debt, says Ortoli. “A home equity loan should only be used for debt consolidation if you have a steady source of income and are confident that you can make all of your payments for the new loan,” Ortoli says.
Weighing the Pros and Cons of a Home Equity Loan to Consolidate Debt
- Interest rates are typically lower than other loans.
- Can be easier to qualify for “since it is a secured debt,” Ortoli says.
- Able to shop for the best terms and lowest interest rates among various financial institutions.
- Funds are received in a lump sum, so borrowers can immediately pay off large debts and other expenses.
- No stipulations on how to use the funds borrowed.
- Rates are typically fixed.
- Putting your house up as collateral where failure to make the payments could lead to the lender putting a lien on your home.
- The easy-to-access loan could mean it’s too accessible for the financially unprepared, Ortoli says.
- If the value of the home falls, home equity loan borrowers may end up owing more than their houses are worth, leaving them in a deeper hole.
- This is a loan on top of an existing mortgage.
Alternative Ways to Consolidate Debt
“Ultimately, consolidation is a powerful strategy, but think of it as a treatment, not a remedy,” Klingelhoeffer says. “The real cure is having positive cash flow and paying down your debt to a manageable level.” Freeing up monthly cash could also allow funds to be directed toward an emergency fund and retirement. Many experts will say this is important to start early as a positive step in wealth-building.
If you don’t want to risk having a lien on your home but are looking to free up cash flow and consolidate debt, there are several alternative ways to consolidate debt.
Balance transfer credit card: Some balance transfer cards offer an introductory 0% interest rate. Most range between 12 to 18 months until the APR takes effect. Multiple debts can be transferred to the card. If you pay off the card balance before the introductory period ends, all your payments will go 100% towards the balance instead of the balance plus interest. This strategy can help pay down debt sooner and save on total interest. Depending on the issuer, there may be restrictions on what type of debts can be transferred, though, where a home equity loan does not have any stipulation on how to use it.
Personal loan: A personal loan could be a better or worse option depending on the APR you qualify for. If the personal loan is unsecured, that means you won’t have to use your home as collateral. And if you can secure a personal loan rate that is lower than a home equity rate, it could work in your favor. Typically, you can use funds from personal loans how you like. Watch out for origination fees and early payoff fees though.
Debt management plan: If you have unmanageable debt and need help sorting through your options, a credible credit counseling agency can help. We recommend using an agency qualified through the National Foundation for Credit Counseling.
Debt settlement plan: Using a debt settlement service can assist with the process of negotiating down your debts. However, the service isn’t free. Ultimately you don’t need to pay for this service since you can contact creditors directly and ask to negotiate or settle owed balances yourself.
Refinancing: Interest rates are low right now, so if you own a home, you could benefit from new, favorable loan terms. Refinancing a mortgage over 30 years can allow you to spread the loan balance over 30 years versus 10 years as with a home equity loan, says Chuck Czajka, founder of financial consulting firm Macro Money Concepts in Florida. If a refinance lowers your monthly mortgage payment, you can put the freed-up cash flow into paying down debts.
A cash-out refinance could also work by taking out a new mortgage that is larger than what is owed but getting a check for the difference, to use as you wish, at closing. Refinancing the entire mortgage and taking out the equity needed to pay off any debts is an option to consider, says Czajka. Pay close attention to the closing costs. Closing costs could outweigh the cost of your debt.
How to Get a Home Equity Loan for Debt Consolidation
If you decide a home equity loan is the best option for you, here’s how to start.
- First, it’s important to know how much your house is worth, so you know how much equity you have.
- Check your credit score and take steps to increase it so you can get a more favorable rate.
- “You can get a home equity loan for debt consolidation by first applying at the bank that holds your mortgage,” Czajka. “This bank will likely know you and will be able to help you get through the home equity loan process more quickly.”
- Shop and compare the best rates, terms, and fees with at least three lenders before applying.