Debt Consolidation vs Home Equity Loans

There can be benefits to using a home equity loan to pay off credit card debt, including lower and fixed monthly payments. If you’re considering a debt consolidation loan, the benefits are similar.

But home equity loans and debt consolidation loans differ from there, and using either to pay off credit card debt could have an impact on your finances.

A home equity loan is a loan drawn on the equity of your home – the difference between what its appraised value is and what you owe on your mortgage. Your home is the collateral – the bank can take it back if you don’t make payments.

There is no collateral involved. If you don’t pay it back, you aren’t going to lose your home.

When you weigh a debt consolidation loan vs. home equity to pay off credit card debt, a lot of factors come into play.

Quick Comparison: Interest Rates, Payments & Financial Risk

Interest Rates

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

Typically, home equity loans have significantly lower interest rates than debt consolidation loans. Both home equity and debt consolidation loans are more likely to be fixed rate, unlike the variable (changing) rates on credit cards. That means payments, which are the same every month, are easier to budget. Interest on home equity loans used to pay off credit card debt is no longer tax deductible.

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. More of your payment on either loan goes to the loan principal, rather than the high and changing interest on a credit card. As mentioned above, payments are fixed, so they are easier to budget. You also have an end-date for the loan payoff, something you don’t have with a credit card.

Financial Risk

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

The biggest drawback to using a home equity loan to pay off credit card debt is that your home is on the line. If you don’t make your payments on the loan, the lender can foreclose.. On a smaller scale, there are fees that may include an appraisal and closing costs with a home equity loan.

With both home equity and debt consolidation loans, another risk is that if you continue to run up credit cards or other debt, the loan will just add to the problem, not solve it.

Debt Consolidation Loans

Debt consolidation loans streamline a bill-paying, combining multiple debts that have different interest rates and payments into one fixed monthly payment. The lender may send you a check, allowing you to pay off creditors, or may pay the creditors directly.

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

If you’re paying off credit cards, which are unsecured debt, the better option is usually an unsecured loan, which are offered by most online debt consolidation lenders. Since there is no collateral, the amount you can borrow likely will be smaller than with a secured loan, and the interest will be higher.

Another option is a debt consolidation plan in which a third party combines your consumer debt and you pay a fixed monthly payment to the company. This can be done through a nonprofit credit counseling agency, or a for-profit debt settlement company. We’ll discuss these options in more detail later.

Home Equity Loans and Credit Lines

Home equity loans and home equity lines of credit (HELOC) use your home as collateral. A home equity loan is a lump sum. A HELOC a revolving line of credit that you can draw from as needed. If you are looking to pay off credit card debt, the equity loan is probably a better option, since it’s a one-time sum of money to you that you can specifically aim at the debt you need to pay off.

Interest rates for home equity loans and HELOCS are much lower than those for credit cards, but, as we’ve discussed, your home is at risk when you draw on its equity.

The benefit of a home equity loan to pay off credit cards is the low interest rate. You’re likely paying at least 16% interest on your credit card balances, and possibly as much as 29%, while home equity loans have interest rates that start between 4.5-6% in 2021, and tend to be in the single digits. The interest rate on credit cards starts at around 15% and can go up if you miss two payments.

Even though you own the home and have a mortgage, to qualify for a home equity loan or HELOC, you must have good credit and a steady income. Home equity loans generally have 15- to 30-year repayment periods. A lot can happen during that stretch of time. You can lose your job, have a medical issue that means lost wages; there could be a slump in the housing market that drops the value of your home below what you owe on it.

If your home’s value decreases, you could be “underwater,” meaning you owe more than it’s worth. If you have to sell your home, you’ll be liable for the difference.

Fees

Drawing on home equity comes with fees for appraisal and closing costs that can add up

Interest

The worse your credit, the higher the interest on your home equity loan will be. The more credit card debt you have, the higher the interest on the card will be.

HELOCs also often have variable, not fixed, interest rates, which means that the interest can increase, so your payments will as well. Home equity loans generally have fixed rates.

Tax Changes

If a home equity loan or HELOC does not specifically pay for home improvements – as defined by the IRS – the mortgage interest can’t be deducted. Before the 2017 tax changes, mortgage interest was deductible, no matter what. If you are getting a home equity loan to pay off credit card debt, that means the mortgage isn’t tax-deductible. The financial benefit of a home equity loan would be less in this case, particularly if the interest rate is high.

How Do I Get a Home Equity Loan for Debt Consolidation?

If you are applying for a home equity loan or HELOC, you already own a home. But the process is still similar to applying for a mortgage.

The lender will likely want the home appraised to determine its value, since this has likely changed since you bought the home. The equity you will draw on will be up to 70-80% of the difference between what you owe on your mortgage and what the home is appraised at.

You will have to supply proof of income, assets and debt. The lender will review your credit report as well.

The process usually takes 30-60 days. It’s the same whether you’re applying for a home equity loan or HELOC. If the loan is to pay off debt, the lender may send payments directly to your creditors, or you get the money and pay the creditors yourself.

Which One Is Better?

Whether to get a home equity loan vs. debt consolidation to pay off credit cards comes down to how comfortable you are with your financial situation.

If you have a lot of equity in your home and believe you won’t have any problem making the home equity loan payments, as well as your mortgage payment, then a home equity loan is a good choice. You will have lower monthly payments and a lower interest rate.

But keep in mind, the payment period will be longer and your home is on the line if your circumstances change and you can’t pay.

With a debt consolidation loan, the monthly payments and interest will be higher that a home equity line of credit, but if you default, the damage is less. While your credit will suffer, you won’t lose your home.

With both, if you run up your credit after taking out the loan, you can end up in a worse financial situation. You have the home equity or debt consolidation loan payments, but also have the new credit card payments to make.

There are other options, including debt management, debt settlement and bankruptcy. You should carefully weigh the pros and cons before you decide how to tackle your debt and consider credit counseling to find out which option is best for you.

Debt Management Plan

Before you consider borrowing more money to pay off credit card debt, you may want to consider debt management.

A debt management plan through a nonprofit credit counseling agency, like InCharge Debt Solutions, can reduce your monthly payments by reducing the amount of interest you are paying, and also combine your payments into one fixed monthly payment.

A credit counselor at a nonprofit debt management company can talk to you – for free – about how to create a budget and go over debt management options. With a debt management plan, the counselor will work with creditors to get an affordable interest rate. You make a fixed monthly payment to the nonprofit debt management company, for a period of 3-5 years, and the company pays down your debt. The program comes with a $40 monthly fee that’s part of your monthly payment. Debt management plans don’t appear on your credit report and, because payments are being made on time, can improve your credit score.

Less Than Full Balance program

If you qualify, a counselor at InCharge Debt Solutions may also suggest the “Less than Full Balance program,” or “Credit Card Debt Forgiveness” as it is sometimes called. The Less than Full Balance program can reduce a balance by 40%-50%. There is no interest charged on payments in the 36-month program.

There are some restrictions:

  • Your creditor must be on the list of banks, law offices or debt collection agencies that participate in the program.
  • You must be 120 days or more behind on the debt.
  • You must owe at least $1,000.
  • The balance also must be paid off in 36 months or less. There are no extensions.
  • If your savings on the balance reduction is more than $600, you will be charged income tax on the savings.

Debt Settlement

With traditional debt settlement, a for-profit company attempts to negotiate a settlement for less than the amount owed. You make monthly payments to an escrow account until they reach the amount large enough to make a lump-sum payment to the creditor. Research this option carefully Fees for the service, late fees on unpaid balances and interest charges on the debt can wipe out much of the savings. And your credit score will take a big hit, losing 60-100 points. It appears on your credit report for seven years.

Bankruptcy

Bankruptcy will discharge your credit card debt and allow you to keep your home as long as you make your monthly 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 whether you file Chapter 7 or Chapter 13.

Tom Jackson focuses on writing about debt solutions for consumers struggling to make ends meet. His background includes time as a columnist for newspapers in Washington D.C., Tampa and Sacramento, Calif., where he reported and commented on everything from city and state budgets to the marketing of local businesses and how the business of professional sports impacts a city. Along the way, he has racked up state and national awards for writing, editing and design. Tom’s blogging on the 2016 election won a pair of top honors from the Florida Press Club. A University of Florida alumnus, St. Louis Cardinals fan and eager-if-haphazard golfer, Tom splits time between Tampa and Cashiers, N.C., with his wife of 40 years, college-age son, and Spencer, a yappy Shetland sheepdog.

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    Sources:

    1. NA (2018, February 26) The Best Debt Consolidation Loans of 2018. Retrieved from: https://loans.usnews.com/debt-consolidation
    2. Dzikowski, P. (ND) Debt Consolidation: Pros and Cons. Retrieved from: https://www.nolo.com/legal-encyclopedia/debt-consolidation-pros-cons.html
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    4. 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/