You’ve made mortgage payments for the past 15 years, your home has soared in value and you now have access to a pool of cash using a home equity loan or line of credit.
Sounds great if you need money to pay off debt, but think before you jump.
Accessing home equity as a refinancing tool is easy, and seems logical, but it is fraught with dangers, the most threatening one being that you could wind up losing your home if there is a downturn in the economy, real estate prices plunge, or you lose your job.
How Home Equity Works for Debt Consolidation
Though home equity loans and HELOCs use the value of your home as collateral, they operate differently.
HELOCs are credit lines, meaning you use as much of a pre-approved loan amount as you want, when you want. The amount you can borrow is based on a number of factors, including the amount of equity you have in your home, your income and your credit score.
A home equity loan is a lump-sum loan and is often called a second mortgage. Lenders will not only want to know how much equity you have in the home and your ability to repay the loan, they want to know what you plan to do with the money. Home equity loans have traditionally been used to add to the value of the house, paying for such things as kitchen remodeling or a new roof.
Pros & Cons of Using Home Equity for Debt Consolidation
While there are a lot of plusses for using home equity to consolidate date, there are some negatives that should be factored into the matter before making a final decision.
Here is a look at both sides:
Pros of Using Home Equity for Debt Consolidation
- Lower interest. Interest rate on home equity loans and HELOCs is usually much lower than on credit card debt because the debt is secured by a house, which raises the likelihood that the loan will be repaid.
- Smaller payments. The reduced interest rate means your monthly payments should be lower and you make only one payment each month.
- Tax deductible. The IRS says that interest on home equity loans is still deductible as long as the loan is used to buy, build or substantially improve the taxpayer’s home that secures the loan. Interest can only be deducted up to $750,000 for a married couple or $375,000 for married taxpayer filing a separate return.
Cons of Using Home Equity for Debt Consolidation
- Could lose the home. The biggest problem with either a HELOC or home equity loan is that you are converting an unsecured consumer debt (credit cards), into a loan that does require collateral that you could lose.
- Can’t be deducted. If an equity loan is used for anything else – to pay off credit card or student loan debt or personal use — it is not tax deductible.
- Market could drop. If the value of your home falls, you might end up underwater, a very common condition after the real estate collapse of 2008. Owing more on a house than it’s worth makes it very difficult to sell.
- Potentially increase debt. If you take an equity loan or HELOC for more than you need to pay off your credit card debts, there always is the temptation to spend unwisely.
Qualifying for HELOC and Home Equity Loans
Lenders won’t give you an equity loan or an equity line of credit unless you meet underwriting standards. Even if you have enough equity in your house to cover what you want to borrow, lenders don’t want to have to foreclose to get their money back. For that reason, they consider other factors, including your income, credit score, other debts, investments, loan-to-value ratio and debt-to-income ratio.
Requiring borrowers to meet lender standards is common practice for all loans. Lenders like equity loans and HELOCs because most borrowers have enough money tied up in their real estate – the collateral – that they are unlikely to default and risk losing their home.
You can’t borrow more than the equity in your home, and usually you can’t borrow nearly that much. Many lenders require that you have a 20% equity cushion, the difference between the home’s value and what you’ve borrowed through a primary and secondary mortgage. If you have a house worth $200,000, you must leave $40,000 in equity untouched. If you owe $100,000 on your primary mortgage, then you potentially could qualify an equity loan or credit line of $60,000.
Types of Debt That Can Be Consolidated
Lenders often want to know what you plan to use a home equity loan for. Debt consolidation for credit cards is one use, but you might want to use the money to build an addition to your house. Expect questions about that. In the past, lenders preferred equity loans be used to make home improvements, adding to the value of the real estate used as collateral, but that isn’t the case today.
There are generally no restrictions on how you use a HELOC. If you want to consolidate debt by paying off a car loan and credit card debt, that’s fine. The lender is only concerned that you repay the interest and principal according to the terms of the loan or line of credit.
Consider Your Options
Unless you have a very solid income and live in an area where home prices are consistently rising, replacing consumer debt with an equity loan is probably not a good idea. The wisest move is to speak with a nonprofit credit counselor or debt consolidation agency for advice and to develop a strategy that doesn’t use your home as collateral.
If your credit score is high enough, you might be able to find a lender who will offer you a personal loan that you can use to repay your credit cards. A personal loan can carry a lower interest rate and collateral is usually not required.
Always consider how much you will save refinancing. New loans usually include origination fees that lenders use to cover things like credit checks and title search. Refinancing might not be worth pursuing if the fees are too high.
If you have an excellent credit score (uncommon for people having trouble making credit card payments) you can also try credit card refinancing with a balance transfer. That involves moving debt from a card with a high APR to one with a lower one. Card issuers offer no-interest grace periods of 12-18 months to lure people to transfer balances.
Finally, you can pursue a debt settlement program where a portion of your debts are forgiven in exchange for a lump-sum payment. This option will have a profound impact on your credit score, but if it’s already damaged, you have little to lose.
About The Author
Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].
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