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Sometimes it makes sense to put all of your eggs in one basket.
Consolidating your debt can help streamline your repayment plan and hopefully save you money in the long run. But when using your home as collateral to secure your existing debt, there are a few other factors to consider – starting with the fact that a default could end up costing you your home.
How to Consolidate Debt Using Home Equity
Debt can add up quickly, and you can find yourself facing multiple payments per month on things like your mortgage, credit cards, and student loans.
âMost consumers face some type of unsecured debt, and COVID has certainly made it more difficult to manage,â says Jeffrey Arevalo, financial wellness expert at GreenPath Financial Wellbeing.
Consolidating your debt means taking out a big loan and using it to pay off your other existing debts. This way, you will only have one loan payment to repay each month, ideally with a lower interest rate on that single loan than on your other existing loans.
For example, if your credit card charges you 16% interest on your lingering credit card debt, and you consolidate that loan into a home equity line of credit at about 4%, then you’re going to save a lot of money on interest.
“For someone who is struggling to pay off their debt, who is not progressing fast enough, who pays high interest rates, or who is just overwhelmed, I would consider a debt consolidation,” Arevalo says.
For those with decent equity in their home, a home equity loan or home equity line of credit (HELOC) can be good tools to consider – if you can benefit from it. Home equity loans have tightened over the past year, making it harder to get these loans if you have a lower credit rating and less equity in your home.
A home equity loan is similar to a traditional loan – you’ll get a lump sum at the start of your term, then monthly payments (plus interest) until you pay off what you’ve borrowed. A home equity line of credit is more like a credit card. It’s a revolving line of credit, which means you choose how much you spend on the line as you go, and then have a repayment period to pay off what you’ve borrowed (plus interest).
Is It A Good Idea To Use Home Equity To Consolidate Debt?
You should seriously consider your repayment plan and whether the underlying behaviors that led to your debt in the first place will continue before taking out a home loan or a debt consolidation line of credit.
âYou want to be so careful of turning unsecured debt into secured debt,â Arevalo says. âIf you were to default on a home loan or a home equity line of credit, you could risk things like foreclosure.â
Yes, you could lose your home if you don’t make your payments.
âI think it’s a dangerous world to borrow from your house to pay off your credit cards, because a lot of times we don’t change our behavior. We end up putting all our piles of debt into one massive pile, âsays Craig Lemoine, director of the Academy for Home Equity in Financial Planning at the University of Illinois.
But if you do it right and make diligent payments, it can be a way to save money on paying down your debt.
Taking high interest loans and consolidating them into a HELOC or home equity loan “could save you thousands of dollars a month,” says Darren Q. English, development loan officer at Quontic.
Again, make sure you have addressed the underlying circumstances that led to your debt in the first place.
âIf it turns out that they can save a lot more money on interest, and they’re okay with turning unsecured debt into secured debt, then a home equity loan would make sense, âArevalo says. “But any behaviors or circumstances that led to the accumulation of debt in the first place must be corrected.”
You’ll want to take a holistic approach to your situation to see if this strategy makes sense. Think about all your income and debts, other regular bills you pay, and your cash flow.
âSometimes getting a loan or a consolidation won’t solve that underlying problem. It could just be a band-aid, âArevalo says.
Home Equity Loan vs HELOC for Debt Consolidation
The principles of using either product for debt consolidation are the same: you will take out your HELOC loan or your home loan, you will use it to pay off the existing debt, and then you will no longer have to worry about that existing loan.
A home equity loan is a more structured traditional loan. You’ll withdraw a lump sum, against your home, and typically consumers can use it to knock out their debts “pretty quickly,” according to Arevalo.
You will have a fixed interest rate for a home loan. This means that you will lock in your interest rate at the start of your loan term and it will not change.
A HELOC, on the other hand, offers a bit more flexibility. It’s similar to a credit card, and therefore your payments will be variable depending on how much you spend on your line. Your interest rate will also be variable with a home equity loan, which means if the rates go up you will be subject to higher interest payments.
With a home equity loan in particular, you’re more likely to have to pay closing costs and get your home appraised, although some lenders require the same metrics for HELOCs. These will be personal expenses.
Pros and Cons of Using Home Equity for Debt Consolidation
Consolidate multiple debts into one payment
Save money on interest
Streamline reimbursement (only one payment to worry about, instead of several)
Converting unsecured debt to secured debt
You could lose your home if you don’t make your payments
May not qualify for an ideal interest rate
Need good credit and a decent amount of home equity to qualify for a home equity loan
Alternative Debt Consolidation Options
If you’re worried about turning your unsecured debt into secured debt, a balance transfer credit card might be a good idea. You may also be able to get a personal loan depending on the amount of debt to be repaid. Both of these options have their own pros and cons, so do your research before you dive in.
Whatever you choose to do, “just be careful not to just transfer your debt to different places instead of dealing with it head-on,” Arevalo says.