What is home equity debt consolidation?
Debt consolidation is a type of financing in which one loan is taken out to pay off other loans and debts. The consolidation refers to the lumping of various debts into one loan which should have a lower interest rate and therefore a lower monthly payment.
One way to consolidate your debts is through an installment loan with your home equity as collateral. This is called a home equity loan.
Benefits of home equity debt consolidation
- Credit cards have much more aggressive interest rates and payment cycles. Home equity loans generally have much lower interest rates.
- When your credit cards are almost maxed out it negatively affects your credit score. To positively affect your credit score, you generally want to owe 30% or less than your max available amount. Consolidating your debt into a home equity loan helps that credit score criteria by bringing you below that 30% mark.
- Home equity interest is tax deductible while credit card interest is not.
- Consolidating debts to free up finances that can be used to invest into your house could be a clever option. This makes sense if the value of your home continues to increase, though it depends on your credit profile.
Home Equity Debt Consolidation Example
Malia has $30,000 in credit card debt, with an interest rate of 15%. If she has budgeted to pay $700 per month on this debt, it will take her five years to pay and she will pay close to $13,000 in interest. If she takes out a home equity line of credit, she gets the $30,000, pays the credit card in full, and avoids incurring any more of the 15% interest on that card. Instead, she takes a $30,000 loan against the equity of her home, and she pays an interest rate of 5.0%. She chooses a five year repayment option, and pays less than $600 per month. Her spending habits change, and she pays her credit card amount in full each month. After five years, she also pays less than $4,000 in total interest on the home equity loan. She pays some closing costs, but these are much less than her original mortgage, and is far less than the interest she would be paying on her credit card. Also, the interest on this loan is now tax deductible, and she avoids any damage to her credit score.
Downsides to home equity debt consolidation
- If the value of your home decreases and you want to sell, you could lose more than your house is worth.
- Repayment terms for home equity loans are generally much longer than credit card debt. In other words, you’ll be in debt longer.
- A home equity loan doesn’t address the spending habits that caused the debt in the first place.
- If you default on your home equity loan, the bank may foreclose on you and take your home.
Another Example of Home Equity Debt Consolidation Example
Malia’s brother Bob has $10,000 in credit card debt. He talks to Malia and learns about her good decision to take out a home equity loan to consolidate her debt, and he does the same. He takes out his bank’s minimum amount for a home equity loan, $15,000, at a 5% rate over 10 years. His habits don’t change much, and he ends up spending the extra $5,000 on renovations and puts $5,000 more on his credit card. Now he’s saddled with an extra $160 monthly payment for the loan, and will have paid over $4,000 in interest over ten years. And he still has $5,000 in credit card debt. Because Bob’s spending habits don’t change, the cycle of debt persists.
Debt can be a burden and must be viewed in the long term. Remember Malia? She could potentially save thousands of dollars by consolidating her debt into a home equity loan, but this is predicated on both the consolidation of her debt and changed spending habits. There is no quick solution for large sums of debt. Depending on your long term plans and spending patterns, home equity debt consolidation could be a great option for you to save money or reallocate finances.
Frequently asked questions about home equity debt consolidation:
Is home equity debt consolidation a good idea for me?
It is possible to have a good credit score while having more than the recommended number of credit lines. If you have a decent credit score but have too many lines of credit opened, home equity debt consolidation might be a great option for you.
However, if you have a poor credit score and decide to consolidate debt into home equity you could be at risk of foreclosure or bankruptcy.
The most important factor in any financial decision is organization. Along with financial organization comes better spending habits. If you don’t change negative spending habits, or address the issues that got you into debt in the first place, debt consolidation may not be the best first step in freeing yourself from debt.
If you have a poor credit score and decide to consolidate debt into home equity you could be at risk of foreclosure or bankruptcy.
Understand that all loan companies are different. Make sure you do your research on the company’s history and successes when it comes to home equity and debt consolidation.
How do I determine which loan option is best for my situation?
Our first recommendation is to speak to one of our mortgage and loan experts. They will be the most helpful when it comes to understanding your financial standing and your loan options.
Another resource to use is our debt consolidation calculator. This calculator will determine the advantage or disadvantage of consolidating various loans and credit card debt.
What is the difference between a home equity loan and a home equity line of credit?
A home equity loan (HEL) is a fixed amount, with equity in your house as collateral. They typically offer a fixed interest rate, fixed term and fixed monthly payment.
With a home equity line of credit (HELOC), you may withdraw money as you need it up to a certain limit, and repay the loan over a fixed term with a variable interest rate. There is typically a “draw period,” during which the funds continue to become available and interest-only payments are allowed. This is followed by a fixed repayment term.
How much home equity can I borrow?
Your home equity loan amount is determined by the equity you have in your home, as well as other factors like your credit score and credit history.