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
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.
Cons of Using Home Equity for Debt Consolidation
You could lose your home
Obviously, this is the big one. If you get behind or default on a credit card, that will have negative consequences for your credit score and ability to borrow money in the future. However, if you don't pay your mortgage, you can lose your home. In some cases, taking out a personal loan to consolidate debt might be a better option.
Equity shouldn't be squandered
If homeowners really need it, having equity to borrow from is a real benefit. On the other hand, that home is an investment. With decent equity, if homeowners need to sell, they can often get money out of the home as a down payment for their next home or for something else they need. It's almost like living inside a savings account. Borrowing that equity puts homeowners in a position of converting that home asset into a liability and potentially being buried in debt.
You could wind up in big trouble again
If consolidating your debt in this way is a step toward "turning the ship around" then it can be a very smart financial decision. If, after sitting in a drawer for a couple of months, that now zero balance card with $20,000 of available credit starts calling to you, and you start racking up debt again, you'll be in a far worse financial situation than you were when you started.
Not everyone qualifies for debt consolidation through a HEL or HELOC. If you have too much debt, if your credit scores have been dinged by late payments or debt write offs, or if you don't have enough equity in your home, you may need to look for other options. The Federal Trade Commission points out that you have to be careful looking for counsel on how to resolve your credit issues, but that many organizations—like credit unions—often offer free consumer credit counseling. Counselors with the National Foundation for Credit Counseling provide free counseling and are governed by strict certification, training, and ethics rules.
Any certified credit counselor and many lending officers can help you figure out the best approach for your circumstances. At CUTX, we work closely with our members to help them achieve their financial goals. Contact us today!