Debt Consolidation with a Home Equity Loan
When you see your monthly credit card statements and the interest you’re paying, does it feel as if the financial roof is about to cave in?
If so, the real roof over your head may provide the best way to eliminate credit card debt.
You can get a home equity loan or home equity line of credit (HELOC) to consolidate your debts and pay off the credit cards. The interest rate is tax deductible and will be so much lower than credit cards, you’ll probably be able to buy a new Spanish tile roof.
What Is a Home Equity Loan?
A home equity loan is borrowing against the value of equity that you have in the house. Equity is the difference between what your home is appraised at, and what you owe on it.
For instance, if your home’s appraised value is $150,000 and you owe $100,000 on the mortgage, you have $50,000 in equity. With a home equity loan, you borrow against that $50,000 and pay it back in monthly installments. That’s why it is often referred to as a second mortgage.
It’s also why lenders are eager to make home equity loans for debt consolidation. The lender already is making money on the first mortgage. Now, he gets to make a slightly higher interest rate on the second mortgage and he still has the same house as collateral.
Don’t confuse a home equity loan for a home equity line of credit. They are two different types of loans.
With a home equity loan, you receive a lump sum and then repay it on a monthly basis. Using the example above, you might borrow $25,000 and make monthly payments that include a fixed-interest rate, for an agreed amount of time.
With a HELOC, it’s similar to a credit card: You receive an open-end line of credit and draw from that as your needs arise. The advantage is that you only pay interest on portion of the line of credit you use.
For example, if you were approved for a $25,000 HELOC based on the equity in your home and used $15,000 of it to get a new roof, you would only pay interest on the $15,000 and still have $10,000 left to borrow against. The other plus is that HELOC’s are considered revolving credit, meaning once you’ve repaid it, you can borrow against it again.
How to Qualify for a Home Equity Loan
Qualifying is almost too easy since the only thing you really need is a house with some equity and there is a lot of equity in the U.S.
A 2016 study found that homeowners have almost $7 trillion in home equity. That would be enough for each owner to pull out $150,000.
While each lender is different, they use the same basic criteria in the approval process. They generally want borrowers to maintain 20% of their equity after taking out a loan.
For instance, if the market value of your home is $300,000, the total amount you owe would have to be less than $240,000, a sum that would include your original mortgage and the home equity loan or HELOC you are seeking.
This lowers the risk for lenders since a borrower who has at least $60,000 invested in an asset is not likely to walk away from it. They also aren’t likely to rent it to anyone who’d turn it into a meth house or indoor chicken hatchery.
Such collateral gives lenders flexibility when evaluating borrowers, but they still rely heavily on credit scores when setting the loan’s interest rate. Anything below a 600 score is considered poor and will make it difficult to get a home equity loan or HELOC. It would be a good idea to get credit counseling to help repair your credit score.
How Much Can I Borrow with a Home Equity Loan or a HELOC?
Some lenders cap the total at $100,000, though the exact amount depends on your equity and creditworthiness. Banks generally allow you to borrow up to 85% of the appraised value of your home, minus what you owe on your first mortgage.
As noted earlier, you also need to maintain 20% of the equity after taking out a home equity loan or HELOC.
Which is Better, a Home Equity Loan or a HELOC?
That depends on your specific needs and financial preferences. Though some lenders offer adjustable interest rates, a home equity loan typically comes with a fixed rate for the entire life of the loan, which is generally 10 to 15 years.
Borrowers tend to prefer that if they have a specific project with a fixed cost in mind, like putting a new roof on their house or financing their bucket-list trip to climb Mt. Everest.
A HELOC is a pay-as-you-go proposition, much like a credit card. Instead of a one-time loan, you have a certain amount of money available to borrow, and you dip into it as you see fit. That gives you more flexibility than a lump-sum loan and offers an immediate source of revenue if an emergency hits.
If you get a home equity loan, you pretty much know how much you’ll be paying each month and for how long. A HELOC’s flexibility means those things fluctuate.
HELOCs have a draw period, usually five to 10 years, when you can borrow funds. Then there is the repayment period, usually 10 to 20 years, during which the money must be repaid. During the draw period, you only pay interest on the amount you borrow.
As you pay off the principal, your credit line revolves and you can tap into it again. Say you have a $10,000 line of credit and borrow $6,000, then you pay back $4,000 toward the principal. You would then have $8,000 in available credit.
HELOC interest rates are variable, meaning they are based on the Prime Rate plus usually 1% or 2%. The U.S. Federal Reserve raised interest rates in March of 2017 by 25 basis points. What that meant to the average consumer was the Prime Rate jumped to 4% and mortgage interest rates increased.
The average 30-year rate has gone from 3.68% in March 2016 to 4.21% in March 2017, and most economists expect it to continue rising. Keep that in mind when you consider the variable rate that comes with a HELOC.
What Are the Benefits of Home Equity Loans and HELOCs?
It’s cheaper money than you’ll find almost anywhere else. The interest rates are lower than just about any other form of financing. The rate on an unsecured personal loan ranges from 6% to 36%.
The average interest rate on credit cards was about 16.5% in the first quarter of 2017. If you’re credit score is poor, chances are you’re paying five to 10 points more than that.
For customers with good credit, HELOC interest rates ranged from 4.5% to 8.15% at five of largest U.S. banks in March 2017, according to Bankrate.com.
Basically, the rate on your home equity loan or HELOC is likely to be 10 to 15 points lower than what credit card companies are socking you with. What does that mean in real dollars?
Say you have $20,000 in credit card debt at 15% interest. That would require 10 years of $323 monthly payment to pay off.
If you got a $20,000 home equity loan at 4.79% interest, your monthly payments for 10 years would be $210.48. That’s a savings of $13,502.40.
Because home equity loans and HELOCs are borrowed against your home, the interest is usually tax deductible. On top of all that, you’re making only one payment a month instead of the however-many you were making to handle all your credit cards.
Pros and Cons of Home Equity Loans and HELOCs
The money saved on interest rates is the most attractive feature of home equity loans and HELOCs. It is substantial and it’s indisputable. There isn’t a cheaper way to consolidate debt.
Another plus is that interest paid is deductible, while the interest rate on credit cards is not.
It could also ease your stress level if you are only making one monthly payment after consolidating your debts, rather than trying to keep up with the deadlines on several bills.
The major drawback with a home equity loan or HELOC is equally substantial and indisputable: You’re putting your home up as collateral and if you fall behind on payments, you could lose the home.
That may not seem like much of a threat when you’re approved for a home equity loan or HELOC, but if you lose your job, are sidelined for several months with an injury or your home loses substantial value because of another collapse in the real estate market, losing your home can become very real.
Some other factors to consider are the fees and closing costs that may be associated with the loan; the length of repayment terms, which can be 10 years or longer; some HELOCs require the balance to be paid off at the end of the draw period.
Is a Home Equity Loan Right for Me?
It very well could be, but ask yourself a couple of basic questions before pursuing a home equity loan or HELOC.
Does it make financial sense? If so, will scratching out of a financial hole only tempt me to fall back into a deeper one?
On the first question, just do the math. Confirm that consolidating your various debts into one monthly payment will be cheaper than paying them individually.
The key is interest rates. If you owe only one year on a car loan at 6.5% interest, it wouldn’t make sense to roll that into a 15-year home equity loan at 5%. So, get out a calculator and crunch all the numbers.
The answer to the second question won’t be so cut-and-dried. A home equity loan or HELOC can provide instant relief from a monthly budget pinch, but it can also lead to a false sense of financial freedom.
Borrowers might be tempted to use the money carelessly (do you really want to use your house as collateral to buy a Louis Vuitton skateboard?). They could also forget they aren’t actually getting rid of debt, they are simply making it easier to pay back.
Borrowers could easily fall back into the spending habits that got them into debt. Lenders call this “reloading,” which is getting a loan to pay off a loan, then using the breathing room to spend more money.
Simply put, no loan makes sense if you don’t live within your means. And if you don’t live within those means with a home equity loan or HELOC, you might lose your most valuable asset – your house.
That’s why many consumers often opt for a debt management plan, particularly if it’s credit card debt. A non-profit credit counseling agency consolidates credit and works with lenders to get you lower interest rates.
As with a home equity loan or HELOC, you make one monthly payment that is lower than the sum of all those individual payments you were making before.
Unlike a bank or other lender, a debt management program also address your financial behavior. Credit counselors help you build a budget and devise a long-term plan to not only get you out of the hole, but also to keep you from falling back in.
When it comes to debt relief, that’s the best strategy of all.
Is Bankruptcy a Better Choice Than Home Equity Loan?
If you are swimming in unsecured debt so deep that not even a home equity loan will remove it, the next option to consider might be filing for bankruptcy.
Unsecured loans like credit cards and medical debt could be more easily discharged in bankruptcy than with a home equity loan.
Filing for bankruptcy will have a direct negative impact on your credit score for 7-10 years, but it also can provide a fresh start or “second chance” on your financial life.
The rule of thumb regarding unsecured debt is that if you can’t pay it off within five years, it’s time look closely at bankruptcy as a way to restart your finances.