How to Use a Home Equity Loan for Debt Consolidation

High-interest debt can make it difficult to stay ahead financially. Credit cards and personal loans often carry interest rates that keep your balances growing, even when you’re making regular on-time payments. Medical bills don’t typically charge interest directly, but they become expensive fast if you put them on a medical card or loan advertising a deferred-interest promotion.

A home equity loan for debt consolidation can allow you to replace several high-interest debts with one fixed-rate loan backed by your home’s equity. While this strategy can lower your interest rate and simplify the repayment process, though, it does tap into your home’s equity. It also puts your house at risk of foreclosure if you fall behind.

Before you move forward with one of these loans, you’ll want to make sure you know how the process works and what’s at stake.

How does using a home equity loan for debt consolidation work?

A home equity loan lets you borrow against the equity you’ve built in your home. You’ll receive a lump sum with a fixed interest rate and fixed monthly payments over a set repayment period, typically 10 to 20 years, with some lenders extending that term to 30 years.

You have two main ways to borrow against your equity. A home equity loan creates a “second mortgage” that sits alongside your original mortgage, which doesn’t change.

A cash-out refinance instead replaces your existing mortgage with a larger one. The lender pays off your old loan and gives you the difference in cash, and you make a single payment on the higher balance.

Unlike unsecured debt, a home equity loan uses your house as collateral. The interest rate is usually lower than those for credit cards and personal loans. However, you risk losing your home to foreclosure if you default on the loan.

Requirements for a home equity loan

The requirements for a home equity loan are similar to those of a mortgage, but you’ll typically need a lower loan-to-value (LTV). Your LTV is a percentage that compares the size of your loan to the value of your home.

You also need more equity in your home than you would if you were buying a house with a traditional mortgage.

Beyond that, lenders typically look for:

• A credit score of 620 or higher
• A debt-to-income (DTI) ratio below 43%, with some exceptions
• Stable income and employment
• A home appraisal to value your residence

Typically, lenders set an LTV of 80% to 85% for a home equity loan. Suppose that your home appraises for $400,000, and you currently owe $300,000 on your existing mortgage. If your home equity lender has an LTV limit of 80%, the most you could finance is $320,000, meaning you could borrow $20,000. Your existing $300,000 mortgage stays as is alongside the new loan.

5 steps to consolidate debt with a home equity loan

Here’s how to use a home equity loan for debt consolidation in five steps:

Step 1: Determine how much equity you have

You’ll need enough equity to borrow against your home and stay under the lender’s LTV threshold, which is usually 80% or 85%. Make sure you are under that limit and that borrowing up to your LTV is worthwhile for debt consolidation.

If you can’t borrow enough money against your home’s equity to pay off your high-interest unsecured debt, taking out the loan may not be worthwhile.

Step 2: Check your credit score and debt-to-income ratio

Usually, you need a credit score of at least 620 to qualify for a home equity loan. If you have a higher score, you may be able to qualify for a lower interest rate.

You will also need an acceptable DTI. Most lenders want a DTI of 43% or less, including the new mortgage payment. Remember, lenders will calculate your DTI using your total housing payments: your existing mortgage plus the new home equity loan (or the single larger payment, if you refinance).

Some lenders will subtract debts you’re paying off with the loan from your DTI, but usually only if those debts are paid and closed at closing. Ask your lender how they handle debts before you apply.

Step 3: Shop for lenders and compare rates

Once you’ve confirmed that you have enough equity and meet the basic requirements, shop for lenders. Compare a few different options to find the best deal for your situation. While lenders set rates based on your credit score and the market, some may offer lower closing costs and origination fees.

Step 4: Apply and go through underwriting

After you’ve chosen a lender, apply for a home equity loan or cash-out refinance. The underwriting process can take several weeks.

Make sure to submit all requested documents to the underwriting team. The sooner you respond with information, the faster your lender can process the loan.

Step 5: Use the funds to pay off existing debts

Once you receive the money, use it to pay off your high-interest debts. Eliminating several monthly payments will make it easier to repay the home equity loan and simplify your budgeting process. Depending on the interest rates on your existing debts and the rate you qualify for, you could end up paying less in interest over the life of the loan.

Keep in mind that it’s important not to run up credit card debt, as doing so defeats the purpose of the loan and can leave you with unmanageable debt.

Pros of using a home equity loan for debt

The benefits of using home equity to consolidate debt include:

• Lower interest rates than many credit cards
• Fixed monthly payments that simplify budgeting
• One monthly payment instead of several
• Predictable repayment schedule
• Potential interest savings over time

You’ll also have a clear repayment timeline because of the fixed terms.

Drawbacks of using a home equity loan for debt

Perhaps the biggest drawback to a home equity loan is that it uses your home as collateral. If you fall behind on payments, your lender can begin foreclosure proceedings. Other downsides include:

• Closing costs and lender fees
• Reduced home equity
• Less flexibility if you decide to sell your home
• The temptation to rack up new credit card balances

Before you borrow against your home, have a clear financial plan in place.

Home equity loan vs. other debt consolidation options

Home equity loans aren’t the only option out there for consolidating debt, with alternatives that can be a better fit, depending on the amount of debt you’re looking to consolidate.

Home equity loan vs. personal loan

The core difference between a home equity loan and a personal loan is collateral. A home equity loan is secured by your house, which is why lenders offer lower rates — they can use your home to satisfy any debt you can’t repay. It’s a good option for large, planned expenses you’ll pay over many years.

A personal loan is unsecured, so the rate typically runs higher, but any default damages your credit rather than putting your home at risk. It’s a good option for smaller needs or emergencies.

Home equity loan vs. HELOC

A home equity line of credit (HELOC) works more like a credit card in that you can borrow money when you need it. You can make several draws from the HELOC during the draw period, up to the credit limit your lender sets based on your equity.

HELOC rates are usually variable, which means payments can rise or fall depending on the market. A home equity loan works better when you know exactly how much debt you want to consolidate and want a fixed payment.

Home equity loan vs. balance transfer card

Many balance transfer credit cards offer a 0% introductory APR, letting you move balances from several higher-interest cards and pay them down interest-free for a set period of 12 to 21 months, depending on the card. Most charge a balance transfer fee of 3% to 5% of each amount transferred, which you’ll want to factor into your budget.

Once that period ends, the interest rate can jump to 15% variable APR or higher, and any balance remaining is charged that higher rate. Focus on fully paying off any balances you transfer before the promo period ends.

Read more >> Understanding debt consolidation loans and their impact on credit

When a home equity loan makes sense for debt consolidation

A home equity loan could be a good fit for your financial goals if you have plenty of equity and stable income. You may want to use the loan to consolidate debt if the following apply to you:

• You qualify for a much lower interest rate
• You want predictable monthly payments
• You have enough equity to borrow responsibly
• You plan to avoid taking on new debt after consolidating

If you’re already struggling to make payments or your income is unstable, other options may be the better choice.

Protecting your credit after you consolidate

Consolidation moves your debt, rather than erases it. Any cards or loans you paid off are still open. And if you charge them up, you’ll owe the same amount plus a loan against your home. Staying current on everything is what keeps your debt from becoming a bigger issue, and it’s what gets you a better rate the next time you borrow.

Kikoff’s Credit Account reports your on-time payments to all three credit bureaus, building the payment history that carries the most weight in your score.