Using A Home Equity Loan For Debt Consolidation – Low Cost Advisor
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As a homeowner, there’s added financial responsibility on your hands, including the mortgage, property taxes, home maintenance and other expenses. There’s a possibility you’re also shouldering high-interest debt such as credit cards. Fortunately, there are ways to pay down your debt down faster with the help of your home.
A home equity loan allows you to use the equity in your property to consolidate debt at a lower interest rate. However, this strategy does come with some drawbacks. Here’s what you should know.
How a Home Equity Loan Consolidates Debt
Home equity is the difference between what you owe on your home (the mortgage balance) and how much it’s currently worth, typically based on the current appraised value. You cannot get a home equity loan unless you have some equity in your home; lenders typically look for at least 15% equity in order to essentially lend that back to you.
The more you pay to your lender, the higher your equity grows. Another way equity grows is when the overall housing market is healthy and home values (or sales prices) in your area are rising. A home equity loan allows you to borrow against that equity in the form of a lump-sum installment loan.
That cash can be used for a variety of purposes, such as making upgrades to your home, paying for college, covering emergency expenses and consolidating debt.
Home equity loans are a good tool for debt consolidation because the interest rates are quite low compared to other forms of debt. Once your home equity loan closes and you receive your funds, you can use the money to pay off your existing debt, and then make a single payment to your lender until the loan is repaid, generally in a span of five to 20 years.
Pros and Cons to Using a Home Equity Loan to Consolidate Debt
When deciding whether or not to use a home equity loan to consolidate debt, there are a few important advantages and disadvantages to consider first.
- Lower interest rates: If you’re looking for ways to borrow money or consolidate debt, a home equity loan offers some of the lowest rates available. Currently, they average annual percentage rate (APR) is around 4% to 6%. Personal loans and credit cards, on the other hand, often have interest rates in the double digits.
- Easier access to financing: While there are certain income and debt balance requirements you must meet, a home equity loan tends to be easier to qualify for than other types of debt. That’s partly because your property serves as collateral, so there’s less risk to the lender than an unsecured loan, which does not have an asset used as collateral, because it can repossess the collateral in the event of a default. Therefore, the lender is more willing to offer a home equity loan.
- Potential for a tax deduction: There’s a chance you can write-off a portion of the interest you pay on your home equity loan. However, you can only take this deduction if you use the money to pay for home improvements. If home renovations are a part of your larger financial plan, it can be helpful to rely on a home equity loan rather than a credit card, especially if you’re also trying to payoff your high-interest debt.
- Risk of losing your home: Because your property serves as collateral, you could lose your home if you fall behind on payments or default. As long as you’re able to keep up on payments, that shouldn’t be a problem.
- Your home could fall underwater: Since a home equity loan draws on the value you’ve built up in your house, there’s a chance you could end up underwater on your mortgage (you owe more than the property is worth) if home values drop. That’s not an issue if you plan to stay in your home for several years, or enough time for the property to recover value. But if you were hoping to move soon, you could end up taking a loss.
- There could be more costs: You may need to pay to have your home professionally appraised in order to determine the value to get a home equity loan. Generally, this costs a few hundred dollars but could be higher depending on where you live and the type of property. You may also have to pay closing costs on the loan.
Is a Home Equity Loan the Best Way to Consolidate Debt?
If you’re in solid financial standing, leveraging your home equity to get rid of high-interest debt faster is a smart move. However, if you don’t plan to stay in your home long, or aren’t confident that your income will be stable throughout the repayment period, you might be better off choosing an alternative method of consolidating debt.
Other Debt Consolidation Options
There are a couple of ways to consolidate your high-interest debt without risking your property.
1. 0% Balance Transfer Cards
To attract new business or issue cards to existing customers, credit card companies will often offer an introductory 0% APR to customers who roll over their existing credit card balance, usually from a competitor.
The introductory period typically lasts 12-18 months, during which that balance doesn’t incur any interest charges. That means your payments go 100% toward paying down the principal balance, allowing you to get rid of that debt faster. Usually, there is a balance transfer fee of 2% to 5% upfront. The key is to pay off your balance before the intro period is over, otherwise you’ll start accruing interest charges again.
2. Take Out a Personal Loan
Personal loans, which are loans you can use to pay for nearly anything up to a predetermined amount, also can help you consolidate debt. Rates are usually lower than credit card rates, at least for borrowers with good credit.
There are two types of personal loans: secured and unsecured. Secured loans are backed by collateral, such as a bank account or vehicle. This helps reduce the lender’s risk, resulting in a lower interest rate. Unsecured loans allow you to borrow money without putting up any collateral; the tradeoff is that the rate may be a bit higher, and you may be subject to more strict requirements.
3. Put Together a Debt Management Plan
If you’re struggling to make payments on unsecured debt, such as credit cards or personal loans, you can consider working with a nonprofit credit counseling agency to come up with a debt management plan (DMP). An accredited counselor will take over your payments and negotiate with lenders on your behalf to lower the cost of your debt. You’ll then make your reduced payments directly to the agency and get regular progress reports. Signing up for a DMP may come with a fee.
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