It’s no secret that a lot of Americans are burdened by debt. As of the first quarter of this year, household debt increased by $148 billion to $17.05 trillion, according to the Federal Reserve Bank of New York. In total, non-housing balances grew by $24 billion.
If you’re among those struggling and are looking for ways to effectively manage your debt, that can mean using a home equity loan to consolidate it. Consolidating your debt with a home equity loan can make it more manageable, while potentially lowering the interest you’re paying on it.
Should I consolidate my debt with a home equity loan?
A home equity loan is basically a second mortgage, which allows homeowners to borrow money using the equity in their homes as collateral. Home equity loans can be used to consolidate your debt, whether that’s credit card debt or auto loan debt. Because there’s currently a record level of home equity, Bill Banfield, executive vice president of capital markets at Rocket Mortgage, says that homeowners who have debt or are looking to make home improvements can consider this option—and it really comes down to the math.
That means knowing your current interest rate on your existing mortgage and understanding what your “blended rate” would be. Your blended rate, Banfield says, is your first lien plus your second lien, if you choose to do that. You’d then compare that to the interest rate on whatever debt you have. Then you can make a choice of “Does it make more sense to do a home equity loan, or does it make more sense based upon what [you’re] trying to accomplish to roll it all into one new first lien mortgage?” Banfield says.
He continued: “You have equity in the property, and you’re only going to do it if it puts you in a better position. So it should relieve debt burden, not make it worse.”
How to use a home equity loan to consolidate your debt
Second mortgages tend to require higher credit, so in order to qualify for a home equity loan, you have to demonstrate that you have the ability to repay the loan. But overall the process for getting a home equity loan is simple. You have to start by reaching out to a lender that offers second mortgages. From there you’ll apply for that home equity loan and the lender will likely review your application (your income and credit score, in particular) and conduct an appraisal on your home. The ability to demonstrate that you’ll be able to repay the loan is key, Banfield says.
“It starts with income,” Banfield adds. “Do you have a stable source of income that we can document to show the ability to repay all of your debts? Number two is credit score; typically you’re gonna see second mortgages are 680 FICO scores or higher…and you need to have equity in the property that you own.”
When it comes to debt consolidation, generally the lender will take a look at all your debt—whether that be credit card debt, student loans, car loans—that you’re looking to bundle all together and consolidate into a single payment. If it were $50,000 worth of debt, they’d break it down and pay those companies.
“So you no longer would have to make payments there, you instead would be making payments on your new second mortgage,” Banfield says. “And like your first mortgage, you’d be making regular and recurring payments.”
Pros and cons of consolidating debt with a home equity loan
Consolidating debt with a home equity loan is always subject to individual circumstances, Banfield says. But because the Federal Reserve has raised interest rates aggressively, credit card rates have gone up and are generally hovering just around 20% and above depending on your credit score, for example.
“So if you can get a home equity loan in the 9% to 10% range, it could be a material savings to you on interest, and you’d have the ability to repay that on a loan that’s fully amortizing over a 20-year period,” Banfield says, adding that’s at least what Rocket Mortgage offers. “So it gives you control, like you’ve consolidated it, you’ve gotten out of the bad credit card debt. You still have the debt, but you’re in a structured product that’s going to allow you to pay it down.”
However, that’s not to say that it’s all good. Let’s say you consolidate all your credit card debt, but then start racking it up again—that’ll put you in a worse financial position. So there is risk, but a lot of it has to do with your choices.
Pros
- Interest rates on home equity loans are typically lower than credit cards, so you’ll likely have a lower monthly payment.
- Home equity loans have fixed interest rates, which means they won’t change if rates go up, so you’ll have a consistent and predictable payment.
- You’ll have one payment, instead of multiple payments, to worry about.
Cons
- Your home is used as collateral, which means you’re at risk of losing your home if you’re not making payments.
- Home equity loans have fixed interest rates, which means they won’t change if rates go down.
- Home equity loans tend to come with closing costs and fees.
Alternative options to pay off your debt
A home equity loans isn’t your only option if you decide that it’s not the right fit for you. For example, there are personal loans that allow you to borrow money from a bank or credit union and make regular payments. Like home equity loans, personal loans have fixed interest rates. But unlike home equity loans, personal loans are not backed by collateral.
Balance transfers are also an option. They’re a type of credit card transaction in which you move outstanding debt from one credit card to another, typically at a lower interest rate. As with any credit card, you should be paying at least the minimum balance and doing so on time.
There are also debt repayment/management plans that you can consider; these are set up and managed by credit counseling agencies, which offer lower interest rates and require a monthly payment.
The takeaway
If you have equity in the property you own, a stable income, and a good credit score—but are in debt, consider consolidating your debt with a home equity loan. If you’re financially responsible, this process can allow you to lump all your debt together into one manageable payment, likely with a lower interest rate. Start by speaking with a lender to see if using a home equity loan to consolidate your debt is the right fit for you.
“You get the benefit of a lower rate because it’s secured your home,” Banfield says. “And if you can put yourself in a material better position, and you’re disciplined, and you’re not going to go out and charge up your credit cards again, the second mortgage could be a really good option.”
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