Managing high-interest debt can feel overwhelming. With interest rates on credit cards and personal loans often hovering around 20% or more, it’s no surprise that many homeowners explore tapping into their home equity as a way to consolidate debt at a lower rate.
Using a home equity loan to pay off debt can be smart, but only if you use this tool correctly. Find out more about using home equity to pay off debt, and how to weigh the benefits and risks.
What is a Home Equity Loan and How Does it Work?
A home equity loan allows you to borrow against your home’s equity — the difference between what you owe on your mortgage and the home’s market value.
This type of loan provides you with a lump sum of money at a fixed interest rate. You also get predictable monthly payments over a set period, typically five to 30 years.
Other Home Equity Financing Options
Alternatives to a home equity loan include a:
- Home equity line of credit (HELOC): A revolving line of credit similar to a credit card that allows you to draw funds as needed during a specific draw period.
- Cash-out refinance: A new mortgage that replaces your current one, with a portion of the new loan provided to you as cash.
Pros of Using a Home Equity Loan to Pay Off Debt
There are several advantages to using a home equity loan to pay off debt, including:
- Lower interest rates: Home equity loans generally offer much lower interest rates than credit cards or personal loans. The average credit card annual percentage rate often exceeds 20%. By contrast, home equity loans may offer rates below 10%, saving from you significant amounts of interest payments.
- Debt consolidation into one payment: Managing multiple debts across credit cards, auto loans, and personal loans can be complicated. A home equity loan consolidates all these obligations into a single monthly payment, simplifying debt management.
- Predictable monthly payments: Since home equity loans have fixed interest rates and repayment terms, you’ll know exactly how much you owe each month. That makes budgeting easier.
- Access to larger loan amounts: Depending on your home’s value and equity, home equity loans may offer higher borrowing limits than unsecured loans. This makes it possible to cover large expenses—such as credit card debt, student loans or medical bills—all at once.
Risks and Downsides to Consider
Using a home equity loan to pay off debt also may come with a few disadvantages, including:
- Risk of foreclosure: A home equity loan uses your home as collateral. If you fail to make payments, the lender can foreclose on your property.
- Closing costs and fees: You’ll need to pay for appraisals, origination fees and other closing costs. These range from 2% to 5% of the loan amount, potentially reducing the financial benefits.
- Increased debt load: Taking out a home equity loan adds more debt to your list of financial obligations. Your debt-to-income ratio may rise, making it harder to qualify for other loans in the future.
- Fluctuating home values: If the housing market declines, you could owe more on your loan than your home is worth, leaving you underwater.
Is It a Good Idea to Use Home Equity for Debt Repayment?
Using home equity to pay off debt can be a smart move in certain scenarios, such as:
- You have a stable income and can comfortably manage the monthly payments.
- Your interest savings from consolidating debt exceed the loan costs.
- You have a plan to avoid accumulating new debt after consolidation.
However, this strategy may not be suitable if:
- Your income is unpredictable or unstable.
- You expect housing market volatility that could affect your home’s value.
- You tend to overspend and risk falling into a debt cycle again.
Home Equity Loan vs. Other Debt Consolidation Options
Here are some of the pros and cons of using alternatives to a home equity loan to pay down your debt:
- Home equity line of credit (HELOC): Offers flexibility in borrowing, and is useful if you need ongoing access to funds. However, it comes with variable interest rates that could increase over time.
- Cash-out refinance: Best when mortgage rates are low, but not as appealing when rates are high. It replaces your current mortgage with a new, larger one. You receive the difference as cash but restart your mortgage term.
- Personal loans: These unsecured loans come with higher interest rates than home equity loans. However, they offer the advantage of not putting your home at risk.
How to Apply for a Home Equity Loan
Here are the steps to applying for a home equity loan:
- Determine your home equity: Calculate your home’s current value and subtract your outstanding mortgage balance to estimate how much equity you might be able borrow against.
- Check your credit score: Lenders typically require a credit score of at least 650-670 for home equity loans. The higher your score, the better the rates for which you will qualify.
- Shop around for lenders: Compare interest rates, fees and loan terms from different lenders to find the best deal.
- Get pre-approved: Some lenders offer pre-approval, which gives you a clearer idea of what rates you qualify for without affecting your credit score.
- Finalize the application: Submit your documents, including proof of income and home value. Then, await approval. If approved, you’ll receive the funds as a lump sum.
Alternatives to Using Home Equity to Pay Off Debt
If you’re unsure about leveraging home equity, consider these alternatives:
- Debt management programs: Work with a credit counselor to create a repayment plan.
- Balance-transfer credit cards: Some cards offer 0% interest on balance transfers for a limited period. This helps you reduce debt without incurring additional interest.
- Personal loans: Unsecured loans can be useful for consolidation, although they typically carry higher interest rates.
- Debt settlement: Negotiate with creditors to settle your debts for less than what you owe. Just note that this can affect your credit negatively.
Example of Using Home Equity to Pay Off Debt
Imagine you have $50,000 in credit card debt with an average interest rate of 24%. By taking out a home equity loan at an 8% interest rate, you could pay off the credit cards and consolidate the debt into a single monthly payment.
The lower interest rate associated with the home equity loan could help you save thousands of dollars over the life of the loan, and predictable payments would simplify budgeting.
However, if you fail to keep up with payments, you risk losing your home to foreclosure. This fact highlights the importance of maintaining financial discipline if you choose this route.
You can use home equity to pay off debt. Using a home equity loan to consolidate high-interest debt offers several advantages, including lower interest rates, predictable monthly payments and access to substantial funds.
By simplifying your debt management and potentially lowering your overall interest burden, a home equity loan may improve your financial situation. However, it’s crucial to carefully weigh the risks, including the potential for foreclosure if you’re unable to make your payments.
Thoroughly assess your financial situation and consult with a financial advisor before making a decision about whether to pursue this approach.
