Know your options for paying off your debt

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 your credit cards. The interest rate on both HELOC and home equity loans is tax-deductible. The interest rates are also much lower than those of credit cards; you may save enough even be able to upgrade a new Spanish tile roof!

What Is a Home Equity Loan?

A home equity loan is often referred to as a second mortgage. It means borrowing against the equity in your home to pay off debt. 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 can borrow against that $50,000 equity and pay it back in monthly installments.

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 still has the same house as collateral.

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

Don’t confuse a home equity loan for a home equity line of credit. They are two different types of loans.

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

A HELOC is another type of loan 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 can draw from that line of credit as the needs arise. The advantage of this option is that you only pay interest 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, 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 for a second mortgage to pay off debt is almost too easy, since the only thing you need is a house with some equity, and there is a lot of equity in the U.S.

A 2018 study found that homeowners have almost $15.2 trillion in home equity, more than double the 2016 equity amount. That is the highest amount of equity Americans have ever seen.

While each lender is different, they use the same essential 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.

If you’re concerned about your score, it  would be a good idea to get credit counseling  from a nonprofit credit counseling agency for tips on improving it.

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 80% 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.

Home Equity Loan vs. 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, which is generally five to 15 years.

Borrowers tend to prefer a second mortgage for debt consolidation if they have a specific project with a fixed cost in mind, like putting a new roof on their house 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. 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.

Pros of Home Equity Loans and HELOCs

Home equity loans and HELOCs are popular ways to pay off credit card debt, but only if you own your home AND have sufficient equity in it. If so, here are some of the pros for consolidating credit card debt with a home equity loan or HELOC.

Lower Interest Rate

The average interest rate for a home equity loan is 5.81% and that rate is fixed. HELOC interest rates are variable, meaning they are based on the Prime Rate plus usually 1% or 2%. The average August 2019 HELOC interest rate is 6.57%.

These interest rates are lower than just about any other form of financing. Unsecured personal loan interest rates generally range from about 6% to 36%, and the actual rate you receive depends on multiple 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%.

The average interest rate on credit cards in August of 2019 was 15.99%.  If your credit score is poor or it’s a new account, chances are you’ll pay 5-10 percent more than that. The current average interest in these situations is an astronomical 19.9%.

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 20% interest. That would require 10 years of $389 monthly payment to pay off for a total of $46,681.

If you got a $20,000 home equity loan at 6.57% interest, your monthly payments for 10 years would be $227.81 for a total of $27,337.20. That’s a savings of $19,349.

Tax Deductible

Because home equity loans and HELOCs are borrowed against your home, the interest is usually tax deductible. The “Tax Cuts and Jobs Act” passed in December of 2017 stipulates that the money must be used to buy, build or substantially renovate the home you’re borrowing against.

Simplify Your Payments

You make just one payment per month, instead of the multiple payments most credit card holders are faced with each month. Using a second mortgage to  consolidate your debts should ease the stress that comes from trying to keep up with the deadlines on several bills.

Cons of Home Equity Loans and HELOC

As good 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

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 a very real possibility.

Fees and Closing Costs

At minimum, you’ll need a home appraisal and likely there will be other closing costs 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.

How Long Will This Take?

The paperwork process for obtaining either a home equity loan or HELOC can 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?

Using home equity to pay off debt could very well could be a good move, 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 you to fall back into a deeper one?

On the first question, 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 won’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 credit card crisis, 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 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 credit card debt in the first place, something lenders call “reloading.” Essentially this is when a borrower gets a loan to pay off a loan, but then uses 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 your 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 to get rid of credit card debt. A nonprofit credit counseling agency consolidates credit and works with lenders to get you lower interest rates.

Unlike a bank or other lender, a debt management program also addresses your financial behavior. Credit counselors 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.

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.


Sources

Kapfidze, T. (2018, December 21). 2018 U.S. Mortgage Market Statistics. Retrieved from https://www.magnifymoney.com/blog/mortgage/u-s-mortgage-market-statistics-2018/

McCann, A. (2019, January 9). What Is the Average Credit Card Interest Rate? Retrieved from https://wallethub.com/edu/cc/average-credit-card-interest-rate/50841/

NA. (2019, February 7). Equity Rich U.S. Properties Increase to New High in 2018. Retrieved from https://www.attomdata.com/news/most-recent/attom-data-solutions-year-end-2018-u-s-home-equity-underwater-report/

NA. (2019, August 14). Current Home Equity Interest Rates. Retrieved from https://www.bankrate.com/finance/home-equity/current-interest-rates.aspx

Carrns, A. (2018, March 9) Interest on Home Equity Loans Is Still Deductible, but With a Big Caveat. Retrieved from https://www.nytimes.com/2018/03/09/your-money/home-equity-loans-deductible.html