Home Equity Loans for Debt Consolidation
Having a lot of debt can feel overwhelming. Even when you're keeping on top of your payments, having to juggle different loans or credit cards with different interest rates and due dates can be stressful. Consolidating that debt into a home equity loan or line of credit (HELOC) gives you one loan with a low interest rate. It all feels so much more manageable. However, while these loans definitely can make life easier, and sometimes save you a lot of money, they can also be the tool by which borrowers land in more trouble than they were in originally.
Home equity is a term that translates to, "the part that the homeowner owns." The money a home owner put down toward the purchase of the home goes to equity. While the first few years' payments mostly go to paying down interest, eventually more and more of the payment goes toward the principal and builds equity. Eventually, the homeowner owns the home outright. At least that's the way mortgages were generally designed. However, when homeowners get a home equity loan or a home equity line of credit, they reverse that process and shrink the amount of the home that they "own" while increasing the amount they "owe."
A home equity loan is an amount the borrower takes out all at once; a home equity line of credit uses that equity portion of the home like a credit card. Homeowners may borrow from it and then pay it back. Of the two, the home equity loan is by far a safer route out of excessive debt.
Both types of loans come with pros and cons:
Pros of Using Home Equity for Debt Consolidation
Save money
Home equity loans tend to have much lower interest rates than, say, credit cards. A $20,000 credit card debt at 16% interest costs the borrower more than $3,000 a year. However, home equity loans are closer to 5% interest; that's only $1,000 a year. The lower rate of a home equity loan could save you $10,000 over five years.
Improve credit scores
One of the key factors in your credit rating is called credit utilization. In other words, if you have a credit card with a $20,000 limit and you owe $19,900, you have utilized almost all the credit on that card. If you transfer that balance to a home equity loan, you suddenly have a $20,000 credit card with nothing on it. So even though you technically owe the same amount of money, your credit utilization has shrunk. That could cause your credit scores to rise within months. With a home equity line of credit, however, your utilization would theoretically go up and down—less favorable on your credit score.
Consolidates debts, no scams
If you have a lot of debt, you probably get offers in the mail to consolidate that debt, or even to negotiate it down. A home equity loan or line of credit is a legitimate way to consolidate debt through your mortgage lender—a reputable institution. Unfortunately, not all debt consolidation offers are equal.
Debt management companies offer to renegotiate your debt. However, what they often do is have you make payments to them, but they don't pay your creditors. They wait until the creditors have written the loan off as a bad debt. Then they sell a reduced payment—the money you've been paying them—to your creditors. Meanwhile, your credit score tumbles. A home equity loan or line of credit won't wreck your credit score and may very well improve it.