Know your options for paying off your debt

That creaking, groaning sound you hear when you dare peek at the interest you’re paying on your credit card balances isn’t your imagination. It’s your financial roof threatening to cave in.

Who can make headway against rates of 18, 24, even 28%? But look up. No, literally: Look up. The real roof over your head may provide the best way to eliminate credit card debt.

If you’ve been in your home long enough to have built up equity, you might be able to cash in on it with a home equity loan or a home equity line of credit (HELOC) to consolidate your debts and pay off your credit cards.

How you propose to use the loan proceeds is between you and the lender. Under the Tax Cuts and Jobs Act implemented in 2018, however, only if you spend the money on eligible home improvements (not maintenance, such as painting) can you deduct interest payments on your income tax.

If you can land a loan tied to your home equity — approvals have been scarce as lenders tighten standards and others pause applications in the Era of COVID-19 — you’ll borrow at interest rates only a fraction of those on most credit cards; you’ll start saving immediately, and may even be able to stash enough to upgrade a new Spanish tile roof!

What Is a Home Equity Loan?

Sometimes referred to as a second mortgage, a home equity loan means borrowing against the equity in your home — that is, the difference between your mortgage balance and your home’s market value.

For instance, if your home is valued at $200,000, and your mortgage balance is $100,000, you have $100,000 in equity. With a home equity loan, you can borrow against that $100,000 (but not all of it, as we shall see), and repay it in monthly installments.

If your income is unaffected by the pandemic and your credit score is strong, your mortgage lender may be eager to negotiate a home equity lender for debt consolidation. The firm already is making money on the first mortgage; now it gets to make a slightly higher interest rate on the second mortgage, and still has the same house as collateral.

Hold on. You’re not locked in. Your first-mortgage holder may not offer the best rate and terms. More than ever, you should shop for a home equity loan just as you would any other significant purchase.

With a home equity loan, you receive a lump sum and repay it at a fixed rate monthly. Using the example above, you might borrow $25,000 and pay off your credit card debt, then make monthly payments that include a fixed interest rate for an agreed amount of time, usually between five and 10 years.

What Is a Home Equity Line of Credit (HELOC)?

A HELOC is another type of loan against equity that can be used to pay off debt. It operates similar to a credit card: You receive a line of credit based on your available equity, and you draw from that line of credit as needs arise.

If you’re struggling to make ends meet, the upside of the HELOC option is you pay interest only on the portion of the line of credit you use, rather than the entirety of the amount borrowed in a home equity loan.

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, interest charges would accrue only against the $15,000, leaving $10,000 to borrow against. Another plus: HELOCs are considered revolving credit, meaning once you’ve repaid it, you can borrow against it again.

Be wary of HELOC terms that allow you to pay only the interest on the amount borrowed for a certain grace period before converting to a traditional home equity loan requiring principal and interest payments. If you haven’t been paying down the balance all along, your monthly outgo will soar.

How to Qualify for a HELOC or Home Equity Loan

Before COVID-19 stuck its ugly nose in the picture, qualifying for a home equity loan to pay off debt was almost too easy. Come to the table with a steady income, a decent credit score, and a house with proper equity, and you were golden.

Now it’s tougher, but not impossible, and American homeowners are riding an precedented wave of equity.

Building on steady gains since the end of the Great Recession a decade ago, U.S. homeowners padded their equity share by $590 billion through the first quarter of 2020 compared to a year earlier — a rise of 6.5%, to a record $19.7 trillion.

While lenders differ in their terms and their risk-tolerance, they apply essentially the same criteria to their approval processes.

  • With some exceptions, borrowers usually must maintain 20% equity stakes after taking out a loan. In the above example ($200,000 value house, $100,000 in equity), no more than $60,000 would be available for borrowing.
  • This lowers the risk for lenders: A borrower with at least $40,000 invested in an asset is unlikely to walk away from it. Homeowners also would be discouraged from renting to anyone who’d turn it into a meth house or indoor chicken hatchery.
  • That $40,000 also insures lenders against losses if the borrower handed back the keys during a market downturn.
  • Substantial 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.
  • Concerned about your score? Consider credit counseling from a nonprofit credit counseling agency for tips on boosting your number.

How Much Can I Borrow with Home Equity Loan or 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 80% of the appraised value of your home, minus what you owe on your first mortgage.

As noted above, it’s important to maintain 20% of the equity after taking out a home equity loan or HELOC. The alternative — and there certainly are lenders who will go above a home’s market value — is higher interest rates and other unfriendly terms.

Choosing Between a Home Equity Loan and HELOC for Debt Consolidation

Choosing between home equity or HELOCs to pay off credit card debt depends on your specific needs and financial preferences. Lenders offer adjustable interest rates on HELOCs, but a home equity loan typically comes with a fixed rate for the entire life of the loan, generally five to 15 years.

Borrowers tend to prefer the predictability of a home equity loan if they have a specific project with a fixed cost in mind — putting on a new roof, adding a room, updating the kitchen — or paying off credit card debt that has flamed out of control.

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 — for instance, for regularly occurring college tuition payments.

HELOCs provide more flexibility than a lump-sum loan while offering an immediate source of revenue if an emergency hits.

If you get a home equity loan for debt consolidation, you pretty much know how much you’ll be paying each month and for how long. A HELOC’s flexibility means those things fluctuate.

As mentioned above, HELOCs have a draw period, usually five to 10 years, when you can borrow funds. After that comes the repayment period, usually 10 to 20 years, during which the money must be repaid. During the draw period, you pay only  interest on the amount you borrow.

As you pay off the principal, your credit line revolves and you can tap into it again. For instance: 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.

Pros & Cons of Using Home Equity Loans

Home equity loans and HELOCs are popular ways to consolidate credit card debt, but only if you own your home AND have sufficient equity in it. Here are things to consider:

Pros

  • Lower interest rate. With the Federal Reserve’s 10-year-bond yield hovering around 0.6%, July 2020 home equity loans are available starting as low as around 4%, with the average hovering just above 5%. With their variable rates, HELOCs can start as low as 2%, with an average of 4.75%.
  • Rates on personal unsecured loans start at just below 6% and range to 36%, depending on factors such as your credit score, annual income, and debt ratios. If you have trouble in any of these areas, expect an interest rate of at least 20-25%.
  • Credit card rates remain no bargain: In July 2020, the average rate was 16.04%, with the average on instant-approval cards coming in at 18.65% and bad-credit cards nudging near a punishing 25%. Looking for quick relief? Be careful out there. The Federal Trade Commission recently issued a complaint against marketers peddling a dodgy credit card interest rate reduction service.
  • 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.
  • Consider: $20,000 in credit card debt at 20% interest would require 10 years of $389 monthly payment to pay off, equalling $46,681.
  • Compare: A $20,000 home equity loan at a gettable 5.25% interest, your monthly payments for 10 years would be $214.58 for a total of $25,750.18 — a whopping savings of $20,931.
  • Tax deductibility? We are tempted to list this in the “Con” section. Passed in December 2017, the Tax Cuts and Jobs Act eliminated the deductibility of home equity loan or HELOC interest except for the purchase, construction, or substantial renovation a home. Tax deductibility should not be a factor in your calculations.
  • Payment Simplification: Instead of the multiple payments most credit-card holders face each month, you cut a single payment to a single lender. Your home equity loan or HELOC should ease the stress attached to trying to track deadlines on several bills.

Cons

As attractive as home equity loans and HELOCs look for solving credit card debt, you must ask yourself:

Do I want to take out another loan to pay back to the loans I already fell behind on?

Here are the some of the negatives to consider before making a final decision:

  • You’re using your house as collateral, putting your security at risk. If you’re laid off or furloughed, 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 a very real possibility.
  • Fees and closing costs add up. At minimum, you’ll need a home appraisal. Count on other fees that add to the cost of the loan. Some lenders even have inactivity fees, prepayment penalties, or cancellation fees. Read the fine print closely before you sign an agreement.
  • You won’t be approved overnight. Before COVID-19 tightened the vise, the paperwork process for obtaining either a home equity loan or HELOC could take 30 days or longer, so don’t be in a rush. The repayment period can be as little as two years or possibly as long as 30 years, depending on the conditions you agree to with the lender. Know what you’re getting into … and how long you’re going to be in it!

Should I Use My Home Equity for Debt Consolidation?

Do the math. Confirm that consolidating your various debts into one monthly payment will be cheaper than paying them individually.

Interest rates are pivotal. Avoid rolling low-interest, short-term debt — say a car loan at 5% with a year to run — into a home equity loan. Get out a calculator and crunch all the numbers.

Numbers work? Great. Now it’s time for The Talk.

Sure, you’re getting relief from high-interest borrowing by tapping your home equity, but are you ready to battle against that false sense of financial freedom?

Borrowers suddenly unburdened return to their spendthrift ways so often it has acquired a term among lenders: “Reloaders.” Be honest: Will you resist temptation?

No loan makes sense if you don’t/won’t live within your means. And if you don’t/won’t live within your means with a home equity loan or HELOC, you could well lose your most valuable asset – your house.

Alternatives to Using Home Equity for Debt Consolidation

Many consumers who don’t trust themselves to go it alone — and others who did trust themselves, and were disappointed — often opt for a debt management plan, particularly if it’s to get rid of credit card debt.

A nonprofit credit counseling agency consolidates credit and works with lenders to secure you lower interest rates. You get a single payment you can live with, with a fixed end date when you will emerge debt-free.

Unlike a bank or other lender, a debt management program also addresses your financial behavior. Credit counseling can help you build a budget and devise a long-term plan to get you out of the hole and keep you from falling back in. When it comes to credit card debt relief, that’s the best strategy of all.

Debt management plans must not be confused with debt settlement, in which a third party attempts to persuade creditors to accept substantially less than what is owed as payment in full. Those don’t always work, and even when they do, your credit score will suffer.

The most drastic choice lies ahead. 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.

But don’t pull that extreme trigger too quickly. Thoroughly explore your options first. If a home equity loan or HELOC can’t solve your troubles alone, give a credit counselor a crack at them. You may be happily astonished at the result.


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