How can a home equity loan help me consolidate debt?
Debt consolidation is a form of debt refinancing that combines all your debts into one affordable monthly payment. You can use debt consolidation for credit cards, auto loans, student loans, and more. For example, if you use a home equity loan for debt consolidation, you can cash out the equity in your home to pay off your debt. While you’ll need to make a fixed monthly payment, the interest rates are often lower than credit card or personal loan interest, saving you money.
What is a home equity loan?
Home equity loans — also known as second mortgages — allow homeowners to borrow money against the equity in their homes. The homeowner repays the loan on top of their original mortgage at a fixed interest rate, with a repayment term of one to thirty years.
You can calculate your home equity by taking the outstanding balance of your loan and subtracting it from the value of your home. Calculate your current home equity with the following formula:
The current appraised value of the home – mortgage balance = home equity
Example: $300,000 appraisal – $180,000 mortgage balance = $120,000 in home equity
Advantages of a home equity loan for debt consolidation
A home equity loan for debt consolidation offers the following advantages:
- Lower interest rate: Since your home secures the loan, it often has a lower interest rate than other options, like personal loans. If your home equity loan’s interest rate is less than your debt’s, you could save money in the long run.
- Fixed interest rate: In addition to low rates, a home equity loan also provides a fixed interest rate — protecting homeowners from a volatile market.
- Single monthly payment: One monthly payment is easier to manage compared to multiple.
- Lower payments: Consolidating your debt into one monthly payment with one interest rate can reduce how much of your monthly cash flow goes to servicing debt obligations.
Disadvantages of using a home equity loan for debt consolidation
It's important to understand the disadvantages to determine if using a home equity loan for debt consolidation is right for you.
- Fees: Home equity loans have several expenses associated with them. First, you'll have to pay for a home appraisal of roughly $300- $400. Additionally, there are closing costs which include loan origination and title fees.
- Possible impact on your credit: Missed payments can damage your credit score. Ultimately, this makes it harder to get approved for other financial products.
- Potential for foreclosure: A home equity loan uses your home as collateral, so missing payments could lead to foreclosure.
How to start the home equity loan process
If you’re looking to use a home equity loan to consolidate your debt, then you can get started with the following steps:
- Assess your debts and equity: Before applying, it's important to know where your debt and equity stand. Do you have enough equity to cover your debts? If you don't have enough equity to tap into, you'll likely be unable to consolidate debt.
- Determine your eligibility: Home equity loans have specific eligibility requirements for homeowners. Lenders typically asses credit score, debt-to-income ratio (DTI), loan-to-value ratio, and employment history.
- Shop lenders: Request information on eligibility and financing requirements, including lending fees and other costs. You'll also want to compare loans to find the most competitive interest rate.
