Debt consolidation programs give borrowers a chance to reorganize their finances and get their cash flow back under control. Sources of funding can come from secured loans, personal (unsecured) loans or even a loan from a qualified retirement plan in some cases. But the most convenient alternative for many homeowners is to simply tap into their home equity and repay themselves. Home equity loans and lines of credit allow homeowners to access their home equity directly with a loan from the lender or a line or credit that provides checks or a debit card. However, homeowners who don’t use them responsibly can end up facing foreclosure.
How Home Equity Loans and HELOCs Work
Home equity loans are secondary loans that are subordinate to the primary mortgage on a residence (if there is one). Home equity lines of credit allow homeowners to draw money out of the equity they have in their homes. They resemble credit cards and other types of consumer debt in that interest is charged only on the amount that is withdrawn. Most of these lines charge a variable rate of interest with low minimum payments. Homeowners usually have ten years after a HELOC is approved to draw out the equity, and then another 15 to 20 years to repay it after the draw period expires. Some banks structure HELOCs so that the borrower makes payments during the draw period that may pay off the loan; there is also an option that locks in a fixed rate on a percentage of the outstanding balance that can be reduced if interest rates drop.
How much someone can borrow is partially based on a combined loan-to-value (CLTV) ratio of 80% to 90% of the home’s appraised value. The amount of the loan or line of credit, as well as the rate of interest charged, will of course also depend on the borrower’s credit score and payment history.
The loan or HELOC can be used to pay off cars, credit cards, student loans or other debts. The goal is to end up with a lower-interest-rate loan with a single monthly payment that is less than the combined payments of the debts the borrower is consolidating.
Because it's a secured loan, home equity loans and lines of credit can be among the easier types of loans to secure for people with some equity built up in their residence. What's more, the interest on this type of loan is deductible in the same manner as conventional mortgage interest for homeowners who are able to itemize their taxes. This is, in fact, the only type of consumer-debt interest other than qualified student-loan interest that can be deducted under any circumstances.
The potential problem with home equity lines of credit is obvious: Failure to repay this type of loan can have devastating consequences. If borrowers become unable to make the loan payments, they may face losing their homes. Their credit scores will also suffer dramatically because of the foreclosure, and they may be unable to secure any other type of financing for some time to come.
To avoid this, homeowners must carefully analyze their cash flow and determine whether they will be able to make their payment each month. If possible, it's wise to make more than the minimum payment, although this can be a secondary factor if the borrower is consolidating high-interest debts that are causing financial ruin.
A Hypothetical Example
Here's how Fred could use a home equity loan or line of credit to consolidate what he owes. He has the following debts:
$10,000 high-interest credit card debt, monthly payment of $172
$4,500 car loan charging 8%, monthly payment of $330
$3,300 of student loan debt that has fallen into default status that had a monthly payment of $150
He has a 30-year mortgage on his home. Because he has used a biweekly payment program that re-amortizes every two weeks, he has accumulated $50,000 of equity in his home and still owes $100,000. With debts totaling well under $40,000 (80% of his equity), Fred can consolidate them using a home equity loan or line of credit, trading three monthly payments for a single, lower payment, with deductible interest. Paying off his three loans will improve his credit, especially because his defaulted student loan will be off the books.
Before doing this, Fred should run the numbers with his bank and make sure the payments are indeed lower than before. In addition, he should try to pay as much as he can on his loan every month to protect himself from foreclosure.The biggest temptation to avoid, if he is taking a line of credit: dipping into the credit line to pay random expenses. He also needs to take care not to run up his credit card bill again.
The Bottom Line
Home equity lines of credit can be useful tools for financially responsible homeowners who need to consolidate their debts. They can provide easy access to capital with lower rates of interest, reduced payments and a tax deduction. But homeowners who misuse these accounts can find themselves out on the street if they become unable to make their payments. For more information on home equity lines of credit and whether they are right for you, consult your loan officer or financial advisor.