Debt Consolidation Loans vs. Home Equity to Pay Off Debts

    Taking out a loan isn't the only way to consolidate debt. Debt management plans provide the same benefits, one monthly payment with lower interest rates, all without the need to borrow money.

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    The spirited revival of the housing market over the last decade has re-opened the door for consumers to use home equity as their bailout tool for high-interest debt – the polite term for overuse of credit cards.

    While the cost of credit card spending soared to a record $1.05 trillion in the summer of 2019, home values were going up, up and further up at the same time.

    According to the Federal Reserve Bank of St. Louis, the average price of houses sold in the U.S. in the first quarter of 2019 was $377,000. That’s $120,000 more than it was a decade earlier.

    The 46.7% increase in equity means homeowners had a lot more money to play with if they wanted to wipe out that weed in the yard known as credit card debt.

    The question is: Do you really want to put your home at risk because you can’t stop pulling plastic out of your wallet?

    Have we forgotten already what happened in 2007-2009 when millions of families went underwater because of inflated home values?

    Is there a better/safer form of debt consolidation out there?

    Let’s look at your options.

    How Debt Consolidation Helps Pay Debts

    First off, let’s make one thing very clear: The question here is not whether consolidation is the best way to attack credit card debt – it is! – but which form of consolidation is best suited to solving your problem?

    A home equity loan is one, and it’s a good one, but borrowing to pay back the loan you couldn’t keep up with from the card companies, is the classic “robbing Peter to pay Paul” strategy.

    If you like the idea of loan, it means you have to get a bank, credit union or online lender involved. They will look at the usual factors involved in borrowing – income, expenses, assets – but what they really look hard at is your credit score, which probably is limping if you aren’t paying off your credit card debt every month.

    Debt management programs are another, less risky, option for dealing with debt from credit cards. Debt management programs don’t look at your credit score when determining who qualifies. If your income exceeds your expenses, you’re in and the payoff time of 3-5 years is about what you’d expect in a loan.

    Here are some pros and cons involved with both choices:

    Pros of Consolidation:

    • The best reason to consolidate is that you will reduce the interest rate on your debt and lower your monthly payment.
    • The second-best reason is that because of those reductions, you should be able to pay off the debt sooner.
    • You will have a fixed payment every month, which makes budgeting a whole lot easier.
    • When you make regular payments, you should be able to pay off the debt sooner.
    • This will simplify your life. One payment, once a month and you’re done.

    Cons of Consolidation:

    • Low interest rate is not guaranteed, especially if you have a spotty record of making payments.
    • Fees will add to your debt. Lenders don’t have to make money somewhere.
    • If you’re thinking home equity, lots of competition here – especially from online lenders – so you must be careful about reading and understanding every line of an agreement.
    • If you’re thinking debt management, you probably will have to close out all but one of your credit cards.
    • Failure to make on-time payments is going to hurt your credit score. In the case of debt management, it could mean the end of the concessions that make the program so attractive.
    • If you don’t change your spending habits, you’ll be back here again … maybe soon!

    Home sitting on stack of cashHow Home Equity Can Pay Debts

    The definition of home equity is the difference between how much you owe on your home and what its current market value is.  For example, if your home is valued at $200,000 and you owe $100,000, you have $100,000 worth of equity.

    Typically, you can borrow up to 80% of that equity ($80,000) and use the money for whatever purpose you want. That could be consolidating high-interest credit card debts; doing home improvements; paying off education costs or any other debts you want to retire.

    A home equity loan is one lump-sum payment from the lender that gets paid back in fixed, monthly payments over a 5-15 year period. A HELOC is a line of credit that you can continually borrow from and pay back over a 10-20 year time frame.

    Pros of Home Equity Loans & HELOCs:

    • Better interest rates. The average interest rate on credit card debt in the summer of 2019 was 16.86%. The average interest for home equity loans was 7.45%.
    • Lower monthly payments. If you borrowed $20,000 over five years at 7.45% to consolidate your credit card debt, you would pay $400 a month for a total of $4,017 in interest. Paying off the credit card at 16.86% over five years would mean payments of $495 per month and $9,733 in interest. You save $5,716!
    • A home equity loans is a fixed monthly payment with a definitive time frame. The rates on HELOCs are variable, but most lenders allow you to convert a portion or all of your loan to a fixed rate.
    • Security matters. The fact that you’re putting your house up as collateral should give you access to larger loan amounts.
    • If you choose a HELOC, you won’t be charged interest until you access the funds.

    Cons of Home Equity Loans & HELOCs:

    • Your home likely is your most valuable asset. If you don’t make payments on the loan, you could lose the house to foreclosure. If you’re struggling with payments on credit cards, think seriously about this before making a decision.
    • Closing costs could negate the gain you made by getting a lower interest rate.
    • If the market value of your home drops, you could end up underwater (house worth less than what you owe on it) and that is a nightmare situation.
    • Tax laws don’t allow you to deduct interest on home equity loans if the money is used to pay off credit cards.
    • If you eventually had to declare bankruptcy, credit card debts is discharged far more often.
    • The repayment terms could be stretched out anywhere from 10-20 years.
    • If you choose a HELOC, be aware of the “hidden” fees that may include an inactivity fee if you don’t use the line of credit, an annual fee, and a prepayment penalty.

    Other Forms of Debt Consolidation

    If you don’t qualify for a debt management program and putting your home up as collateral for a home equity consolidation loan scares you, there are other options that may help you eliminate credit card debt.

    • If your credit score is up to it – 680 or higher is the recommended level – you might qualify for a 0% interest balance transfer credit card.
    • It’s possible you could qualify for an unsecured personal loan (also known as a debt consolidation loan) that won’t require you to use your home as collateral.
    • Borrowing against your retirement account should be the last thing to consider, but again, you have a chance to eliminate high-interest credit card debt and pay yourself back, rather than a bank. There are many negatives associated with this form of borrowing, so be careful.

    Bottom Line

    Debt management programs and home equity loans are equally appealing – and equally effective! – for different reasons.

    Debt management programs don’t ask you to take out a loan. You are not “robbing Peter to pay Paul.” You are being given a second chance to manage your money responsibly and if you follow the program, you should be out of debt in three years.

    Home equity loans are a popular choice for consolidating debt because lenders make it easy to qualify and when done properly, the math works out very nicely for the consumer.

    In other words, both sides of the equation – lender and borrower – get a win out of the deal if everyone does their part.

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    Author

    Staff Writer

    Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it seven years ago, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering college and professional sports, which are the fantasy worlds of finance. His work has been published by the Associated Press, New York Times, Washington Post, Chicago Tribune, Sports Illustrated and Sporting News, among others. His interest in sports has waned some, but his interest in never reaching for his wallet is as passionate as ever. Bill can be reached at bfay@debt.org.

    Sources

    1. NA. (2019, May 31) Average Sales Price of Houses Sold for the United States. Retrieved from https://fred.stlouisfed.org/series/ASPUS
    2. NA. (2019, March 26) Average U.S. Credit Card Debt in 2019. Retrieved from https://www.magnifymoney.com/blog/news/u-s-credit-card-debt-by-the-numbers628618371/
    3. NA. (2019, June 3) Home Equity Loan Rates. Retrieved from https://www.bankrate.com/home-equity.aspx
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