Should you use a home equity loan to consolidate debt?
- Better Borrowing
- Frontwave Credit Union
With home values continuing to rise across San Diego, San Bernardino, and Riverside County, you may be wondering about tapping into your home’s equity to consolidate credit card balances, student loans, or other debt. In certain situations, it can be a good choice. But there can also be downsides. Check out our list of things to consider before getting a home equity loan for debt consolidation.
1. Assess Your Outstanding Debt
Start by taking a detailed look at the debt you’re thinking of consolidating. How much do you owe on each debt? What’s the interest rate? How long would it take you to pay off the debt at your current pay off rate? (Check out our Credit Card Payoff Calculator for help determining this.) Once you know where you currently stand, you can better assess whether a home equity loan is the right move.
2. Determine How Much Equity You Have in Your Home
In simple terms, equity is the difference between how much you owe on your mortgage and the current value of your home. So if your home is worth $700,000 and you owe $400,000 on your mortgage, your equity is $300,000.
Exactly how much of that equity you can borrow against depends on the loan type and the lender. Most lenders offer a maximum loan-to-value or "LTV." LTV equals the percentage of your equity used when your first mortgage and home equity loan (sometimes called a second mortgage) is combined. So if you have 40% equity in your home, and you want to borrow half of that (20%) with a home equity loan, your LTV would equal 80% (60% first mortgage + 20% home equity loan).
3. Research Your Loan Options
Once you've determined you have enough equity in your home to cover your existing debts, you can move on to researching home equity loan options. You’ll want to pay particular attention to the interest rate and terms available. If the interest rate on a home equity loan is lower than what you’re currently paying and/or the term would help you pay off your debt sooner, it might be a good option for debt consolidation.
However, if the home equity loan interest rate is higher than what you’re currently paying on your debt, it may not be a good idea to consolidate your debt that way, as you may end up paying more in the long run. Similarly, if you’re on track to pay off your debt in the next year or two, but a home equity loan term is 5 or 10 years, you may end up paying more in interest over the life of the loan.
Also be sure you’re clear on the difference between a home equity loan and a home equity line of credit (HELOC). The terms are sometimes used interchangeably, but these loan types can actually be quite different.
With a home equity loan, you get all the money you want to borrow all in one lump sum, so you can consolidate your debt all it once. It comes with a fixed term (such as 10, 15 or 20 years) and you’ll have a fixed monthly payment. A home equity loan is often recommended for debt consolidation.
A home equity line of credit, on the other hand, is more like a credit card. You get a limit (your equity) that you can borrow against and you only pay interest on the amount you actually withdraw. You can choose when and how much money to borrow over time. But because of this, your interest rate and payments can vary over time. HELOCs tend to be recommended more for instances where you’ll have ongoing expenses over time, such as during a home remodel or when paying for college tuition. If you choose a HELOC for debt consolidation, you’ll need to be very disciplined about not taking on additional debt as you pay down your initial balance.
4. Understand the Pros and Cons
A home equity loan with a lower interest rate can be a helpful way to consolidate debt into a single monthly payment that saves you money over time. But you should always keep in mind that what you borrow is secured by your home. If you’re unable to make your payments, your home could be foreclosed on.
Also, while home prices are on the rise today, they could fall in the future. If you use up all of your home’s equity now, you could end up owing more than your home is worth. For these reasons, you should always take a careful look at how much you can truly afford to borrow and how you plan to pay it back.