Sometimes it makes sense to put all 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 additional factors to consider, starting with the fact that defaulting on repayment could end up costing you your home.
How to Consolidate Debt Using Your Home Equity
Debt can pile up quickly, and you could find yourself dealing with several payments a month for things like your mortgage, credit cards, and student loans.
“Most consumers are dealing with some type of unsecured debt, and COVID has definitely made it more difficult to manage,” says Jeffrey Arevalo, financial wellness expert at GreenPath Financial Wellness.
Consolidating your debt means taking out a big loan and using it to pay off your other existing debt. This way, you will only have one loan payment to make each month, ideally with a lower interest rate on that single loan than you have on your other existing loans.
For example, if your credit card charges you 16% interest on your lingering credit card debt and consolidate that loan into a home equity line of credit with a rate of around 4%, you’re going to save a lot of money on interest.
“For someone struggling to pay off debt, not growing fast enough, paying high interest rates, or just plain overwhelmed, I would consider debt consolidation,” Arevalo says.
For those with decent equity in their home, a home equity loan or home equity line of credit (HELOC) may be good tools to consider – if you can qualify. Home equity loans have tightened over the past year, making it harder to get these loans if you have a lower credit score and less equity in your home.
A home equity loan is similar to a traditional loan: you’ll receive a lump sum at the start of your term, then monthly payments (plus interest) until you repay what you 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 back what you borrowed ( plus interest).
Is it a good idea to use the equity in your home to consolidate your debt?
You should seriously think about your repayment plan and whether the underlying behaviors that led to your debt in the first place are going to continue before you take out a home equity loan or debt consolidation line of credit.
“You want to be so careful when turning unsecured debt into secured debt,” Arevalo says. “If you were to default on a home equity loan or home equity line of credit, you could risk things like foreclosure.”
Yes, you risk losing your home if you don’t make your payments.
“I think it’s a dangerous world to borrow from your house to pay off your credit cards, because so often we don’t change our behavior. We end up putting all our piles of debt into one massive pile,” says Craig Lemoinedirector 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 off your debt.
Taking out high-interest loans and consolidating them into a HELOC or home equity loan “could potentially save you thousands of dollars a month,” says Darren Q. Englishdevelopment loan officer at Quontic.
Again, make sure you’ve addressed the underlying circumstances that led to your debt in the first place.
“If it turns out that they can save a lot more money on interest and they’re okay with turning unsecured debt into secured debt, that’s when a home equity loan would have meaningful,” says Arevalo. “But any behaviors or circumstances that led to the accumulation of debt in the first place must be taken into account.”
You’ll want to take a holistic approach to your situation to find out if this strategy makes sense. Think about all your income and debts, other common bills you pay, and your cash flow.
“Sometimes getting a loan or a consolidation won’t solve that underlying problem. It could just be a band-aid,” Arevalo says.
Home equity loan vs HELOC for debt consolidation
The principles of using either product for debt consolidation are the same: you’ll take out your HELOC loan or home loan, use it to pay off existing debt, and then just 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 generally consumers can use it to eliminate debt “fairly quickly,” according to Arevalo.
You will have a fixed interest rate for a home equity 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 so your payments will vary depending on how much you spend on your line. Your interest rate will also be variable with a home equity loan, which means that if 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 for HELOCs. These will be reimbursable costs.
Advantages and Disadvantages of Using Home Equity for Debt Consolidation
Consolidate multiple debts into one payment
Save money on interest
Simplify repayment (only one payment to worry about, instead of several)
Convert 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 to have good credit and a decent amount of home equity to qualify for a home equity loan
Alternative Debt Consolidation Options
If you’re considering debt consolidation but aren’t sure if it’s right for you, contact a consulting agency who can help you with your decision.
If you’re worried about turning your unsecured debt into secured debt, a balance transfer credit card might help. You can also get a personal loan depending on the amount of debt you need to pay off. Both of these options have their own pros and cons, so do your research before diving in.
Whatever you choose to do, “be careful not to just move your debt to different places instead of dealing with it head-on,” says Arevalo.