How to use home equity to pay off debt

As a homeowner, you can take advantage of a unique debt relief option — using your home equity to pay off existing debts. By tapping into your home's wealth, you can consolidate your debt, reduce interest expenses, and streamline your monthly payments. You can choose from a variety of products aimed to help you achieve your goals. So, how do you select the right home equity tool to start the process of getting your personal finances back on track?

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In this blog, we'll show you how to use home equity to pay off debt and discuss everything you need to know – including pros and cons, financial factors to consider, and how to choose the best equity product for your specific needs. 

Pros and cons of using home equity to pay off debt

Leveraging equity to pay off debt has its pros and cons. It’s important to understand the gains and potential risks before making a decision. 

Advantages of tapping into home equity

Lower interest rates

Home equity financing products have lower rates compared to credit cards and personal loans. By effectively refinancing your debt at a lower interest rate, you can save money on overall interest payments.

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Single payment 

Borrowing against your home could enable you to consolidate your debts into a single payment. Consolidation can be a time saver if you have multiple due dates and balances to keep track of. A single payment also reduces the risk of missing due dates and accumulating late fees. 

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Flexible loan terms

Repayment terms vary from product to product, which empowers you with flexibility. For example, if debt repayment is just one of several goals, you can choose a longer term that helps you balance your short and long-term financial planning.   

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Potential to pay down debt faster

Another major advantage is the ability to pay off your debt faster. Lower monthly payments help free up your cash flow, which you can then use to chip away at more debt. As an added bonus, paying down debt faster will improve your financial stability and creditworthiness.

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Access to financing 

Obtaining a traditional loan with a blemish on your credit history can be challenging. However, lenders are sometimes willing to provide equity financing to homeowners with less-than-excellent credit because they can use their homes as collateral. 

Risks of tapping into home equity

Foreclosure

The most significant disadvantage of using equity to finance any venture is the risk of losing your home. Putting up your property as collateral gives the lender the right to take your home through foreclosure if you fail to make payments.

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Underwater mortgage

Another key disadvantage is the possibility of owing more on your mortgage than your home is worth, often referred to as an “underwater” mortgage. Being underwater on your mortgage isn’t a good situation because it prevents you from refinancing or selling your home — unless you can cover the difference out of pocket.

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Reduced equity

Once you draw on your home’s wealth, you’ll be limited in terms of when and how much equity you can tap into in the future. Often, you’ll need to pay off whatever you owe or gain more equity before withdrawing more. However, it’s not impossible to take out multiple home equity products on the same property. 

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Various fees

You’ll be on the hook for various expenses, such as application fees, appraisal fees, and closing costs. Depending on your financial situation, these additional expenses may not be worth the cost. 

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Not tax-deductible

Lastly, using home equity loans to pay for anything other than home improvements disqualifies you from deducting mortgage interest from your annual tax bill. 

How to use home equity to pay off debt 

1. Take stock of your finances

Before using home equity to pay off debt, it's critical to understand your financial situation. Begin by listing all your outstanding debts, interest rates, and monthly payments associated with each. In doing so, you’ll know how much you need to cover all your debts. 

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Next, determine your home equity, which is the current market value of your home minus any outstanding mortgage balance. This will provide insight into the potential funds you'll have available for debt repayment. Most lenders expect you to have a combined loan-to-value ratio (CLTV) of 80% or lower, meaning you own at least 20% equity in your home. 

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Finally, review key financial health factors. When determining eligibility, lenders tend to prioritize your credit score, debt-to-income ratio (DTI), and income level.

Understanding where you are financially will help guide your decisions and even determine the products you're eligible for. 

2. Determine the best home equity product for your debt repayment goals

It’s important to explore the different kinds of equity financing products available and how they can impact your finances in the short- and long-term. 

Home equity loan

A home equity loan provides a lump sum of cash upfront. Monthly payments begin almost immediately and are paid over 30 years at a fixed interest rate. 

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Using a home equity loan to pay off debt is an attractive option for homeowners who want to consolidate their high-interest debts into one lower-interest debt over a longer period. 

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Eligibility:

• Credit score: typically 620 or higher
• CLTV: 80-85% or lower
• DTI: 43% or lower

Home equity line of credit (HELOC)

A home equity line of credit works like a credit card, allowing borrowers to access funds as needed up to a certain amount. Once the ten-year draw period is over, the 20-year repayment period begins. Borrowers are on the hook for paying the principal and the interest accumulated on the credit line. HELOCs have variable interest rates, so the monthly payments fluctuate. 

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HELOCs are best suited for homeowners who are looking for more flexibility in their loan amounts and are comfortable with inconsistent interest rates. 

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Eligibility:

• Credit score: typically 680 or higher
• CLTV: 80-85% or lower
• DTI: 43% or lower

Cash-out refinance

A cash-out refinance replaces your existing mortgage with a larger one, allowing you to pocket the difference in cash. Rather than the addition of monthly payments, you’ll have one larger monthly mortgage payment. It’s important to note you’ll receive a new rate and terms. As a result, refinancing your mortgage is advised when interest rates are low. 

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Refinancing to pay off debt is a smart option for homeowners willing to pay extra on their mortgage or are looking to secure a lower rate in addition to debt relief. 

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Eligibility:

• Credit score: generally 620 or higher
• CLTV: 80% or lower
• DTI: 45% or lower

Home Equity Investment (HEI) 

A Home Equity Investment allows homeowners to access the equity in their property without taking out an additional loan. Instead, you receive a lump sum of cash in exchange for a share of your home's future appreciation. You can buy back your equity anytime during the 30-year repayment term, penalty-free. There are no monthly payments. 

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HEIs are an attractive financing option for homeowners who want to avoid taking on additional debt or monthly payments. 

Eligibility:

• Credit score: 500 or higher
• CLTV: 70% maximum
• DTI: varies by individual FICO score
• No income requirements 

Reverse mortgage

A reverse mortgage is an equity financing option available exclusively to homeowners who are 62 or older. Qualifying homeowners can receive equity in cash through a lump sum, monthly installments, or a line of credit. No monthly payments are required; repayment occurs when the borrower passes away, or the property is sold. 

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Reverse mortgages are often seen as a tricky financial product as they come with many conditional requirements. The most notable are maintaining sufficient homeowners insurance, staying current on property taxes, maintaining upkeep on the property, and continuing to live in the home as your primary residence. Failing to meet these requirements can trigger your balance to become immediately due. 

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Eligibility:

• Age 62 years or older
• No income or credit score requirements
• Must own at least 50% equity

3. Shop lenders and apply for the funds

Once you've determined which product to use and how much to borrow, it's time to explore providers. Compare interest rates, fees, repayment terms, and customer reviews to make an informed decision. 

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Before applying for a home equity product, organize and gather any necessary documents for the loan application process. This typically includes proof of income, employment verification, recent tax returns, and documentation related to your home, such as mortgage statements and property appraisals. Preparation can help streamline the process and get you funded faster. 

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Once your application is submitted, you can expect to go through the underwriting process, which is where a provider assesses your eligibility. 

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The timeframe for getting funded after approval varies from product to product. It’s critical to keep up with your debt payments while waiting to get your cash or credit line in hand.

4. Pay off your debts

There’s no denying getting a cash windfall is exciting — it can feel like winning the lottery. However, it’s important to stay focused and committed to your debt repayment goal. If you’ve tapped enough equity to clear all your debts, be sure to follow through and do so. If you didn’t draw enough to settle your accounts, consider prioritizing high-interest debts first to save the most on monthly payments. 

You’ve paid off your debt – now what? 

Using your home equity to pay off debt allows you to break the debt cycle. To avoid falling back into debt:

• Create a budget: Track and manage your monthly cash flow to prioritize paying off your equity product. If you have a tight budget, consider cutting expenses. 
• Build an emergency fund: Allocate a portion of your monthly cash flow to safeguard your finances from unexpected or unplanned expenses. 
• Deactivate your credit cards: Avoid taking on new debt by temporarily deactivating or putting away credit cards. 

Final thoughts on paying off debt using home equity

As a homeowner, you have the option to leverage your home's wealth to pay off crippling debt and get your finances back on track. With the right equity product, you can expedite debt repayment, lower monthly payments, and save on interest expenses. However, it's also crucial to carefully consider the risks of tapping into your equity and ensure that the strategy aligns with long-term financial goals. 

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Achieve greater financial freedom and stability with a Home Equity Investment from Point. Borrowers benefit from no monthly payments, flexible credit evaluations, and the ability to use the funds as they need. Explore Point’s HEIs here.