Using a Home Equity Loan for Debt Consolidation: Pros & Cons

The first thing that’s important to understand is the difference between home equity loans and home equity lines of credit (HELOC). While the two may sound similar — they provide cash in the same way, after all (by tapping into the equity you’ve built in your home) — on closer inspection you’ll find they’re actually very different:

Home Equity Loan

Home equity loans are second mortgages that let you convert your home’s equity into cash. The amount you can borrow is almost always lower than the original mortgage, and repayment periods are generally shorter. Once the loan closes, you’ll receive a lump sum of cash and begin to make payments in addition to your original mortgage payments.

Home Equity Line of Credit

While similar to a home equity loan, a HELOC gives you access to your home’s equity in the form of a credit line instead of a lump cash payment. Once approved, you’ll be able to draw money from your available credit for a set amount of time (usually up to 10 years), making monthly payments on what you use — much like a credit card. It’s important to note that a HELOC isn’t intended for minor expenses.

Whether using a home equity loan to pay off debt is the right strategy for you largely depends on your eligibility. There’s much more to qualifying for a home equity loan than simply being a homeowner. To apply, you should ideally have the following:

• A debt-to-income (DTI) ratio below 43%
• A credit score of at least 620
• A minimum of 15% equity in your home

As you’re considering this option, it’s important to note that these are minimum requirements. These benchmarks are what lenders use to determine how likely it is that you’ll be able to make your loan payments, so a lower DTI and higher credit score can go a long way toward improving your chances of getting approved.

Though an attractive option, using home equity as a means of debt consolidation may not be the best course of action for everyone. With a home equity loan, nonpayment or failure to repay the loan according to the agreed-upon terms can result in foreclosure, so in addition to meeting the minimum eligibility requirements you should:

• Have a stable, reliable source of income. Your income is also an aspect of your finances that potential lenders will pay close attention to when you apply for a home equity loan. Without sufficient means to repay what you borrow, you risk violating the terms of the loan.
• Be financially responsible. A home equity loan as a means of consolidation is only a viable option if you’re able to address the spending habits that initially drove up your debts. If you continue to rack up credit card debt after taking out a home equity loan, for example, you’ll only dig a deeper hole for yourself.
• Have total debts that amount to less than half of your gross income. Anything over this total is too much debt to warrant putting your home up as collateral. If this is your situation, it may be best to consider other debt relief options.

Weighing the pros and cons is an important part of any decision-making process, but it becomes an even more crucial step when the choice you’re making can hold significant consequences for your financial future. To make this process as approachable as possible, we’ve compiled a list of benefits and drawbacks to consider as you decide whether home equity loan debt consolidation makes sense for your circumstances.

Benefits of Home Equity Debt Consolidation Loans

• Lower interest rates. As a type of secured loan — one that’s tied to a form of collateral — home equity loans tend to have lower interest rates when compared to their unsecured counterparts, such as personal loans. Lower interest rates also mean that a greater percentage of your monthly payment gets put toward paying down your principal.
• Fixed interest rates. When you’re approved for a home equity loan, the interest rate you’re offered gets locked in, meaning it won’t be impacted if rates go up.
• One, centralized payment. If you have debts in a variety of places, a home equity loan enables you to pay them in full and reduce the number of monthly payments you make to just one — the one you make to your home equity loan lender.
• They can save you money. Thanks to their lower rates, home equity loans can ultimately save you thousands of dollars in interest payments over time.

Drawbacks of Home Equity Debt Consolidation Loans

• They use your home as collateral. This means that if you can’t make your loan payments for whatever reason, you risk losing your home to foreclosure.
• Fixed interest rates. Fixed interest rates are a double-edged sword — while a plus if rates go up, should they decrease, you’ll still be locked into the higher rate you secured on approval.
• Potential for fees. Closing costs, including origination, home appraisal and credit report fees, are typically your responsibility when applying for a home equity loan. Even though they tend to be lower than the closing fees associated with conventional mortgages, they’re still an added expense to consider.
• The possibility of ending up “underwater.” By taking out a home equity loan, you are essentially transferring a portion of the equity you’ve built to the bank, which means that your stake decreases. Should your home also lose value during this time, you could wind up owing more on your loan than it’s worth.

If using a home equity loan to pay off debt sounds like a good fit for your financial situation, the next step is to apply. As with any loan application, the process of applying for a home equity loan can be intimidating, which is why it’s always a good idea to be prepared before getting started. Here’s what you need to know:

1. Figure out your finances before applying. All home equity loan applications require detailed information about your finances — including your credit score, the value of your home and the amount of equity you have in it. Having this information readily available in advance will save you time and stress as you move through the application process.
2. Shop around. The most costly mistake you can make is to sign paperwork with the first lender you speak to. To ensure that you get the best deal, it’s crucial to approach several different lenders to see what rates and terms are available.
3. Complete the loan application accurately and in full. Applications will typically ask you to verify your income and employment as well as provide detailed information about your finances. You’ll need to provide this information in its entirety to ensure that your application gets processed quickly, as any omissions or errors can lead to delays.
4. Get a home appraisal. In order to determine the amount of your loan, the lender will need an official valuation for your home. The cost of the appraisal will typically be your responsibility.
5. Sign the loan closing documents. Once your application is approved, you’ll need to sign on the dotted line before receiving your cash. These documents are legally binding, so it’s crucial to review the paperwork in full to ensure that the agreement terms are correct before signing.

While home equity loans can be a great way to consolidate debt for some, it isn’t necessarily the best route for everyone. If you’ve weighed the pros and cons and determined that you’re better off pursuing a different avenue for getting your finances back on track, you still have plenty of options to consider:

• If you still like the idea of using home equity to pay off your debt but would rather not access it by taking out a second mortgage, it may make sense to pursue a HELOC instead.
• A cash out refinance is another way to tap into the equity you’ve built in your home. It involves replacing your current mortgage with one that enables you to borrow more money than you currently owe on your home — and receive the difference in cash.
• As a form of unsecured loan, personal loans can be an attractive option if using your home as collateral deters you from applying for a home equity loan. However, because they’re unsecured, personal loans tend to have higher interest rates.
• Another way to consolidate your outstanding balances is by working with a credit counselor to create a debt management plan (DMP). A DMP consists of monthly payments spread out over several years (up to five) to pay down your debts and may come with a lower interest rate.
• If your debts have become overwhelmingly high, your best option may be filing for bankruptcy. This process typically settles debts for less than the amount owed but also comes with repercussions, such as impacting your credit reports and rendering you unable to qualify for a new mortgage for a set period of time.

Whether your debts are best managed by taking out a home equity loan or a different method altogether — such as a HELOC — at Blue Water Mortgage, our experienced team has the knowledge and ability to help you find the right solution. We utilize a transparent approach to assess your current financial status, understand your goals and identify the right option for your unique needs.

As independent mortgage brokers, we have the advantage of working with multiple lenders to shop around and find you the most competitive rates. You will benefit from our expertise and advocacy on your behalf, as well as our thorough understanding of the home equity loan application process. Plus, you’ll have peace of mind knowing that we are available 24/7 via phone to address any concerns or questions you might have.

To speak with one of our mortgage specialists today, contact us here. We are excited to start a conversation about how we can offer a solution to meet your goals!

Or, download a copy of our free eBook, 105 Mortgage FAQs: A Guide for First Time Buyers & Experienced Investors, to get the answers to all your mortgage questions.