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 and you could wind up losing your house if there is a downturn in the economy, real estate prices plunge, or you lose your job.
Using an equity loan to pay off debt has some advantages, but also comes with risks. Consider these:
- Any equity you pull out of your house requires a second mortgage which, just like a primary mortgage, needs to be repaid or your home will be confiscated through foreclosure. Though home equity lines of credit, known as HELOCs, often allow you to use equity for a decade while only paying interest on what you borrow, you will eventually be required to pay both principal and interest, adding a fresh debt burden. That could come as a financial shock when you need it least.
- Home equity loans use your house as collateral. If you miss required payments, the lender can file to foreclose on your property. Even if you have a personal emergency that makes it difficult or impossible to make the required payments, you could still lose your home and all the value you have in it.
- Paying off your debts with money from a home equity loan or HELOC won’t change the spending problems that led to your debts. If you continue to misuse credit cards, you will be faced with fresh debt on top of the required home equity loan payments.
HELOC or Home Equity Loans for Debt Consolidation
Though HELOCs and home equity loans 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. The lender will assess your creditworthiness and the local real estate market to decide how large a credit line it will offer and at what interest rate.
The amount can be substantially less than your home equity. Lenders usually require that you maintain at least 20% equity in your property.
A home equity loan, on the other hand, is usually 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.
Using a home equity loan for credit card debt works for some people but could lead to disaster, especially for those with trouble managing consumer debt. The biggest potential problem is that you convert a consumer debt, which doesn’t require collateral, into a home loan that does require collateral. There are other pros and cons in using a home equity loan for debt consolidation:
- Interest on home equity loans is usually much lower than on credit card debts. Since credit cards don’t involve collateral, lenders have a hard time getting their money back if you stop paying, and often end up selling the debt to a collection agency. Home equity loans are secured by a house, which raises the likelihood that the loan will be repaid.
- You no longer must pay a variety of credit card companies, and the much lengthier repayment period on a home equity loan means your monthly payments could be much smaller.
- 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. If the loan is used for anything else – to pay off credit card or student loan debt or personal use — it is not deductible.
- It’s nearly impossible to discharge a home loan: You either pay it or your home goes into foreclosure. Credit card debt is dischargeable. If you have a hard time managing debts, the chance that you might lose your home makes the conversion of consumer debt to property debt very risky.
- If the value of you home falls, you might end up underwater, a condition common after the real estate collapse of 2008, when home values plunged across the country. Price trends vary by market, so it doesn’t take a national collapse for the value of your house to fall. If you owe more than your house is worth and a recovery in the market seems distant, you might decide to forfeit your house, a step that can severely damage your ability to borrow for years to come.
- If you take an equity loan for more than you need to pay off your credit card debts, or have a home equity line and use it to buy more things after you pay down your consumer debt, you might end up owing more than you did before you consolidated your debts with the equity money.
The rules governing home equity loans and HELOCs are very similar. 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. You should consider consolidating credit card debt without using home equity first. To do that, talk with a nonprofit credit counselor to develop a strategy.
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.
A loan-to-value ratio is the amount you owe on your home compared to its value. If your home is worth $100,000 and you owe $80,000, the ratio is 80%. Your debt-to-income ratio is an expression of your monthly debt obligations as a portion of your monthly income. Generally, the portion can’t exceed 43% in order to qualify, though lenders prefer something less than 35% in order to offer their best loan rate.
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. Foreclosure rates have been very low historically, except during the Great Recession of 2008
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.
Saving Money with a Home Equity Loan
Reducing interest payments is the main advantage of debt consolidation using a home equity loan. If you owe $10,000 on your credit cards and your combined interest rate averages 20%, you would owe $2,000 a year in interest on the balance, assuming it didn’t change. Usually, you will also have to pay some principal each month.
Home equity loans almost always come with lower interest rates. Instead of a 20% APR, your annual interest might be as low as 5% in the summer of 2018. If you opt for a HELOC, you might not have to make any principal payments during the first 10 years that you have the credit line. After that, you can no longer borrow using the line and you must repay both principal and interest. If you can’t make the payments, you could lose your home.
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 pay interest and principal according to the terms of the line of credit.
Consider Your Options
Restructuring your debt without a home equity loan is possible. You should consider seeing a nonprofit credit counselor or debt consolidation agency for advice and to develop a strategy, which can involve repaying high-interest debt first or negotiating a reduction in what you owe with your creditors.
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 than your credit cards. Whether you are using a personal loan or a home equity loan, you should consider how much you will save refinancing. New loans usually include origination fees that lenders use to cover things like credit checks and title research. If you only save 1 or 2 percentage points on the interest payment, refinancing might not be worth pursuing.
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 often offer no-interest grace periods of as long as two years 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.