Home equity loans typically have relatively low interest rates, especially compared with unsecured forms of debt like credit cards. If you are one of millions of Americans saddled with consumer debt, taking out a home equity loan to pay off your higher-interest debts can be a very attractive option.
- Consolidating higher-interest-rate debt from a credit card or personal loan to a lower-interest-rate home equity loan can help you pay off your debt faster and for less money overall.
- If you can’t make payments on your home equity loan, you could lose your home in foreclosure.
- If your home’s value decreases below the balance on your home equity loan and mortgage, you may be unable to sell your home or move.
- Make sure to address the causes of your high-interest debt so that you don’t end up trapped in a home equity loan debt cycle.
Pros and Cons of Using a Home Equity Loan to Pay Off Debt
Interest rates for home equity loans are significantly lower than rates on many other types of debt. If you are able to afford only a fixed amount every month to pay off debt, taking out a home equity loan to pay down your loan balances can help you settle debt more quickly. A lower interest rate means that a greater portion of your monthly payment each month goes toward paying down the principal. From a purely financial perspective, paying off your higher-interest debts with a lower-interest home equity loan will save you the most money in the long run.
There are several cons to using a home equity loan to pay off debt, and they shouldn’t be ignored. While you may intend to use your home equity loan to settle debt, you could find yourself using your lump sum frivolously and end up in even more debt. If you use your home equity loan to settle your debt and end up unable to pay down your home equity loan, you could lose your home to foreclosure. While defaulting on your unsecured debt could hurt your credit for years, defaulting on your home equity loan will hurt your credit and make you homeless.
Even if you use your home equity loan responsibly and make payments every month, you could end up underwater on your loans if your home value decreases. In this situation, you may be unable to move from or sell your home for years while you pay down your loans or wait for your home’s value to increase.
Consolidating higher-interest debt into a lower-interest home equity loan may be the smartest thing from a mathematical perspective, but don’t ignore emotional and behavioral concerns. Daniel Yerger, a certified financial planner and owner of MY Wealth Planners, cautions that “consolidating high-interest debt into a home equity loan can be a great money-saving technique, but it’s only helpful if the underlying cause of the original debt is addressed.”
If you have a high balance of consumer debt and are using a home equity loan to pay it off, make sure that you address the causes of your high balance so you don’t end up in the same situation a few months or years ahead. Consider downloading a budgeting app to track spending, and make sure that you’re using money for things that you truly value. Make sure to build up savings in an emergency fund so that you aren’t running up balances on high-interest credit cards when something comes up.
What is debt consolidation?
Debt consolidation is taking out a new loan to pay other loans. Taking out a home equity loan to pay off older debts is a form of debt consolidation.
Do I need good credit for a home equity loan?
While every lender’s requirements vary, you’ll typically need good credit to get approved for a home equity loan. Because home equity loans are secured by using your home’s equity as collateral for the loan, you may be able to be approved for a home equity loan even if you don’t qualify for an unsecured loan such as a personal loan.
Can I get approved for a home equity loan if I have a lot of credit card debt?
Yes, you can get approved for a home equity loan even with a lot of credit card debt as long as your income is high enough and you have sufficient equity in your home. Lenders look at multiple factors when you apply for a home equity loan, such as:
- Typically wanting a combined loan-to-value (CLTV) ratio of 85% or less. This means that your mortgage balance plus the home equity loan balance divided by your home’s value equals less than 85%.
- Considering your debt-to-income (DTI) ratio. Your DTI ratio is the total of your monthly debt payments divided by your gross monthly income. Most lenders prefer your DTI ratio to be 36% or less.
The Bottom Line
Consolidating higher-interest debt into a lower-interest home equity loan can help you pay off debt faster and cheaper. Make sure that you understand the risks of a home equity loan before you sign up for one, and set yourself up for future success by addressing your money habits first.