Should You Be Using a Home Equity Loan to Pay off Debt?
Debt consolidation is one of the most common reasons for obtaining a home equity loan. Home equity loans often come with much lower interest rates compared to credit cards and other sources of debt. However, tapping into your equity is not always the best financial decision. Here is what you should know before using a home equity loan to pay off debt.
What is a home equity loan?
A home equity loan is a type of secured loan that is secured using a portion of your home’s equity as collateral. You receive a lump-sum payment and repay it over time. The payments are often divided equally over a fixed term, as with a standard mortgage.
Along with repaying the balance, your monthly payments will include interest and extra fees. According to the Federal Trade Commission, lenders may charge the following fees for home equity loans:
- Application fees
- Loan processing fees
- Underwriting fees
- Appraisal fees
- Document preparation fees
- Administrative fees
The extra fees are typically combined with interest to determine the annual percentage rate (APR) for the home equity loan. According to Bankrate, the average APR for a home equity loan is 6.25%.
Many lenders limit the amount that you can borrow to 85% of your available equity. Your equity is the difference between the remaining balance on your mortgage and the value of your home.
For example, if your home is worth $200,000 and you have $150,000 remaining on your mortgage, you have $50,000 in equity. You may qualify for a home equity loan up to $42,500 (85% of $50,000).
Unlike a credit card or unsecured personal loan, home equity loans are secured. You use your home as collateral by placing a second lien on your home. If you default on the loan, the lender can begin foreclosure proceedings to recoup the money.
What is a home equity line of credit?
A home equity line of credit (HELOC) is a form of revolving debt instead of installment debt. Unlike a home equity loan, you do not receive a lump sum of funds. You receive a line of credit.
As with a credit card, you have a credit limit that you can access as needed. Depending on the lender, your account may include checking and routing numbers or come with a debit card for accessing the funds.
HELOCs include interest charges and additional fees. However, you are only charged interest on the balance of your account instead of the total credit limit. If you do not anticipate needing a large lump sum immediately, you may save money with a HELOC compared to a home equity loan.
For example, you are planning on paying off your debt and completing some home renovation projects using equity from your home. With a HELOC, you could pay off the debt and then access funds as necessary to complete your projects.
Most HELOCs come with a draw period, which is the timeframe during which you can access your line of credit. The draw period is often 10 years. You may also have the option of making interest-only payments during the draw period.
When the draw period ends, you can no longer access funds and must begin repaying the principal with interest. The repayment period is typically 20 years.
Home equity loans and HELOCs allow you to use equity to borrow money. However, each option has separate pros and cons. The following video from The Motley Fool helps break down some of the differences between these two options:
What are the advantages of a home equity loan?
A home equity loan allows you to access a large sum of money in a short time, making it useful as a debt consolidation strategy. Along with the ability to borrow more money, home equity loans may offer the following advantages:
- Your credit score is not the biggest concern
- You will likely receive a better interest rate
- You may consolidate multiple sources of debt
Credit scores influence every loan application. However, home equity loans are secured using equity from your home.
With secured loans, your credit score carries less weight when evaluating your ability to repay the loan. Lenders tend to focus on your monthly income and total debts, along with available equity and the amount that you want to borrow.
If you have bad or poor credit, a home equity loan may be your only option for obtaining a large amount of cash.
For example, you may not get approved for a $10,000 personal loan with bad credit. However, lenders may approve a home equity loan in the same amount, as they can recoup their losses if you default on the loan.
You are also likely to receive a better interest rate compared to other debt consolidation solutions. If the interest charges on your credit cards or personal loans are making it difficult to pay down debt, a home equity loan may make sense.
As mentioned, home equity loans have an average interest rate of about 6.25%. The researchers at WalletHub found that the average interest rates for credit cards vary from 19.3% to 23.13% for those with good or fair credit.
The average APR for unsecured personal loans ranges between 13.5% and 19.9% for those with good or fair credit. The money that you save on interest could be used to pay down debt faster.
A home equity loan can also be used for any purpose, including paying off debt from multiple sources. Home equity loans simplify debt management when you have multiple credit cards, personal loans, and other sources of debt.
What are the potential risks of a home equity loan?
The largest risk of a home equity loan is failing to pay your loan. The number of missed payments permitted before the lender begins legal proceedings varies.
Missing two to four payments may cause the lender to start the foreclosure process.
Losing equity in your home is another issue with obtaining a home equity loan to pay off debt. You gradually build equity as you pay down your mortgage. Some homeowners may experience regret or stress by connecting more debt to their homes after spending years paying down their mortgages.
A home equity loan does not eliminate your debt. You are simply moving one or more sources of debt to a new loan – hopefully with a much lower interest rate.
Keep in mind that most of the risks related to home equity loans are temporary or avoidable. If you make your payments on time, you do not need to worry about defaulting and losing your home. As you pay off your loan, you also gradually rebuild the equity that you lost.
How do lenders determine interest rates for home equity loans?
Consumers rarely receive the advertised interest rate for home equity loan products. After you apply for a loan, the lender reviews your credit history, income, and debts to evaluate your creditworthiness.
Some of the factors that influence interest rates for home equity loans and HELOCs include:
- Credit scores
- Debt-to-income (DTI) ratios
- Loan-to-value (LTV) ratios
- Current Federal interest rate
The interest charged for most types of debt is initially influenced by the current Federal interest rate. Lenders also look at your credit score. However, your credit is less of a concern with a home equity loan as you are using your equity as collateral.
The bigger concerns are your debt-to-income (DTI) ratio and your loan-to-value (LTV) ratio. The DTI ratio compares your total monthly financial obligations to your monthly income.
For example, if you have a monthly income of $2,000 and spend $800 per month on rent, credit cards, and other debts, you have a DTI ratio of 40%. Forty percent of your income goes toward paying debts.
Many lenders require a DTI ratio of 36% or less. If you have a higher ratio, you may need to find ways to cut expenses or increase your income.
Lenders also consider the loan-to-value (LTV) ratio. The LTV ratio is equal to the amount of the loan divided by your available equity.
For example, if you have $20,000 in equity and want to borrow $15,000, your LTV ratio is 75%. Most lenders offer the most favorable interest rates for loans with an LTV value of 80% or less.
Does a home equity loan hurt your credit?
Obtaining a home equity loan has a minimal effect on your credit score. A study completed by LendingTree found that the average borrower saw their credit score temporarily drop by just 13 points after taking out home equity loans.
While taking out a home equity loan has a minor impact on your score, defaulting on the loan has a major impact. If you stop making payments, you can expect your credit score to plummet and risk losing your house.
A home equity line of credit (HELOC) can also influence your credit score. It is typically listed as revolving debt, as with credit cards. Having multiple sources of revolving debt can lower your score.
Using all your available credit may also hurt your score. Most lenders prefer to lend money when borrowers have a credit utilization ratio of 40% or less. Credit utilization is often measured as the percentage of credit used compared to your credit limit.
When is it a good idea to pay off debt with home equity?
A home equity loan may make the most sense when the following conditions apply:
- You have a significant amount of debt
- You do not have an excellent credit score
- Most of your existing debt carries higher interest charges
- Your equity is greater than your total high-interest debt
Lenders are less willing to loan money to those with less than stellar credit. According to Experian, if your FICO score is below 669, you are in the “subprime” group of borrowers.
Individuals in the subprime group are more likely to have loan applications denied, receive higher interest rates, or require collateral. In these situations, you may be able to use your equity to get a home equity loan.
Home equity loans also make sense when your existing debt carries higher interest charges. The interest rate on a second mortgage is likely to be much lower compared to the APR on your credit cards, car loan, and other debts.
Getting a home equity loan may also be a good idea when you have more equity compared to the debt that you hope to consolidate. For example, you have a total of $6,000 in credit card debt across multiple cards and $10,000 in equity in your home. The available equity is more than enough to cover the debt.
When is it a bad idea to pay off debt with home equity?
A home equity loan may not be the best idea if you struggle to manage your budget and pay bills on time. Defaulting on a home equity loan may result in foreclosure.
You may also find better solutions for paying off debt in specific situations. If you have good or excellent credit and interest rates for mortgages have dropped since you purchased your home, cash-out refinancing may make more sense.
Cash-out refinancing involves taking out a bigger loan to replace your original mortgage. After covering the original mortgage with the new loan, you pocket the remaining funds.
For example, you have $100,000 remaining on a mortgage for a home valued at $175,000. You could likely obtain a new mortgage for up to $163,750 (85% of $75,000 in equity plus the outstanding $100,000 mortgage). After paying off the $100,000 and covering any fees, you would have about $60,000 in cash.
Cash-out refinancing often results in a lower interest rate compared to a home equity loan. However, lenders may be less willing to refinance your mortgage if you have poor or bad credit.
Should you get a home equity loan to pay off your debt? A home equity loan may make your debt more manageable, as they often have much lower interest rates compared to credit cards and personal loans. However, you need to ensure that you can afford the monthly payments on the loan to avoid defaulting and potentially losing your home.