Which Is Better: Debt Consolidation or Home Equity Loan?

Choosing between debt consolidation or a home equity loan to pay off credit card debt is like picking between two poisons. Either one might get the job done, but both will cause pain and uncertainty.

Quick Comparison: Interest Rates, Payments & Risk

Interest Rates

  • Home Equity Loan: lower interest rate
  • Debt Consolidation Loan: higher interest rate

Typically, home equity loans offer significantly lower interest rates than debt consolidation loans.

Payments

  • Home Equity Loan: lower monthly payment
  • Debt Consolidation Loan: higher monthly payment

Because home equity loans have longer terms (up to 30 years), payments can be significantly lower than debt consolidation loans which have terms between 3-5 years.

Financial Risk

  • Home Equity Loan: Higher risk
  • Debt Consolidation Loan: Lower risk

A home equity loan can lead to foreclosure if you cannot afford to make your payments.

Both debt consolidation and home-equity borrowing offer paths out of debt, but each demands scrutiny.

Debt Consolidation Loans

Debt consolidation loans are a way to take the stress out of the credit card bill paying process.

Instead of multiple debts from multiple creditors with multiple interest rates and multiple payment deadlines, you have one payment to one company, once a month.

They are available from a variety of lenders, including banks, credit unions and peer-to-peer lenders. Banks and credit unions prefer to offer secured loans, which look and act a lot like home equity loans because collateral is involved.

However, it is recommended you seek an unsecured loan, especially if it’s being used to pay off unsecured debt like credit card bills.

Other debt consolidation lenders operate online and are more likely to offer unsecured loans. Since the loans aren’t secured with valuable collateral like a house or a car, the amount you can borrow likely will be smaller than what you might receive from a secured loan and the interest rate almost certainly will be higher.

Another option is a debt-consolidation plan that is managed by a third party. It combines all you consumer debt into a single loan that is repaid with monthly installments.

The third party, generally a nonprofit credit counseling agency works with your credit card companies to develop a repayment plan that includes a significantly lower interest rate. The plan also might include a decrease in the principal owed if your creditors are willing to write down part of your debt. Commonly, a debt consolidation plan is unsecured, meaning you don’t have to pledge property or a retirement account as collateral.

Home Equity Loans and Credit Lines

Home equity loans and credit lines (called HELOCs) use your dwelling as collateral for either a lump-sum loan or a line of credit.

Since the loan is secured by your house, interest rates can be quite low relative to what you’ve been paying on your credit card balances. However, taking a home equity loan means you could lose your house if you can’t make the payments.

Home equity loans are mortgages taken against the value of your home less what you might owe on it through a primary mortgage. If you own a home that appraises at $300,000 and you have a $150,000 balance on your mortgage, you have $150,000 in home equity. Typically, a home equity lender will allow you to borrow 70%-80 of that equity.

The benefit of using a home equity loan, or a home equity line of credit (HELOC), is the interest rate. Credit card lenders often charge 20% or more in annual interest on unpaid balances, but the interest rate on a home equity loan in 2018 can easily be less than 5% annually. That might sound like a great trade off until you consider the pitfalls.

The first problem is the loan application itself. You often need to provide detailed information about your personal finances to qualify for a home equity loan, including evidence of a steady income. There also are closing costs that include appraisal fees, filing fees and other lender fees that can add up.

The bigger problem comes in the trade off. If you have a mountain of unsecured debt and pay it off using the proceeds of an equity loan or HELOC, the amount you owe becomes secured debt. That means if for some reason you can’t meet the minimum monthly payment on the equity loan or credit line, the lender can put you loan in default and begin foreclosure proceedings on your home.

Home equity loans frequently come with 15- to 30-year repayment periods. A lot can happen during such a long stretch of time – you could lose your job or a slump in the housing market could drop the value of you home below what you owe on your mortgage and equity loan. In that case, if you sell the house for less than you owe, you will be forced to make up the difference between the sales price and what you owe the lenders. Many homeowners were caught in that trap after the national housing-price bubble burst in 2008 that unleashed a wave of foreclosures when unemployed homeowners discovered they couldn’t sell their houses and pay off their mortgages.

Yet another problem is the interest rate. In order to get a low rate on an equity loan, homeowners usually take a variable rate repayment plan. If interest rates increase, as they have in 2018, the cost of your equity loan also increases. Homeowners can get a fixed rate that won’t change, but that generally means paying a few percentage points more for the loan.

Creditworthiness is also an issue. The best home equity and HELOC rates go to those with outstanding credit scores. If you have a large amount of consumer debt, it’s unlikely you have an outstanding credit score, which probably will mean you will pay a higher interest rate on your home loan than someone with a sterling credit score.

Finally, prior to the federal tax reform act of 2017, homeowners could use the proceeds of a home equity loan or HELOC for whatever they wanted and then deduct the interest paid from their income tax. But tax law now forbids that. Unless the money is used for an expense related to the dwelling – say a new roof – the interest is no longer deductible.

Which One Is Better?

The pros and cons for debt consolidation loans vs. home equity loans are so similar that the final decision really comes down to whether your willing to risk losing your home to save a little money.

You will have lower monthly payments and pay less in interest with a home equity loan, but you also could lose your home if you default on those payments. That’s a heavy price to pay when you already are struggling financially and don’t know for sure that things will change in the future.

A debt consolidation loan will cost you more, but the penalty for defaulting is considerably less. Your credit score will suffer, but you should not lose your home. Your monthly payments will be higher, but if, for example, you lose your job and can’t make payments until you find another one, you won’t see a foreclosure sign go up in your front yard.

Debt consolidation loan payments can be spread out over a long period, meaning your monthly payments will be lower than if you didn’t consolidate. You also should also be wary of hidden costs. These costs, which can be added to what you owe, couple with potentially high interest rates, mean you could pay more to consolidate your debts than if you tried to work out a repayment plan with each of your card issuers individually.

Somewhere in between debt consolidation loans and home equity loans is the debt consolidation program or debt management plan as it is more commonly known. If you qualify, a debt management plan can reduce your monthly payments by reducing the interest rate paid, but you generally are asked to surrender all but one credit card. If you fail to make the monthly payments, the credit card company can cancel the interest rate concession it made and you’re right back where you started.

If you are uncertain which route to take, contact a nonprofit debt counselor for advice. Consider every avenue – sometimes transferring debt to a credit card offering a zero-interest promotional rate might offer the financial wiggle room you need to avoid setting up a new loan.

If you have a manageable debt, an amount that is smaller than your annual income, you should consider a repayment plan. If your debt exceeds your annual income, repayment could be very difficult, if not impossible, and you probably should consider debt settlement or filing bankruptcy.

Debt settlement is negotiating with the creditors to reduce the amount owed. Some people see as much as a 50% reduction in principal owed, but when you add in fees, penalties for late payments and interest charges, the total saved probably will be closer to 25%. Also, debt settlement causes a dramatic drop in your credit score and is a stain on your credit report for seven years.

In bankruptcy, you can often have your consumer debt discharged and still keep your home as long as you are able to make the mortgage payments. It is a complicated process that usually requires hiring an attorney and can damage your credit report for 7-10 years, depending on which chapter of bankruptcy you choose to file.

You should carefully weigh the pros and cons before you decide how to tackle your debt and consider getting advice from a nonprofit credit counselor.

Sources

NA (2018, February 26) The Best Debt Consolidation Loans of 2018. Retrieved from: https://loans.usnews.com/debt-consolidation

Dzikowski, P. (ND) Debt Consolidation: Pros and Cons. Retrieved from: https://www.nolo.com/legal-encyclopedia/debt-consolidation-pros-cons.html

Hamm, T. (2016, April 5) Why You Should Avoid Debt Consolidation Programs and What to Do Instead. Retrieved from: https://money.usnews.com/money/blogs/my-money/articles/2016-04-05/why-you-should-avoid-debt-consolidation-programs-and-what-to-do-instead

NA, ND. Dangers Presented by Home Equity and Debt Consolidation Loans. Retrieved from: https://www.pacificbankruptcy.com/articles/dangers-presented-by-home-equity-and-consolidation-loans/

 

Jack Preston
jpreston@incharge.org

Jack Preston has won many awards as columnist and writer for newspapers, magazines and websites. He has written about Super Bowls, national and local politics, crime, business and many other topics in a career that has carried him from Florida to California and many stops in between. He uses this experience to offer insights and suggestions on the best ways to deal with debt in today's turbulent economy.