Should you use a home equity loan to consolidate debt?

The past few years have strained many Americans’ wallets, with some well behind their savings goals. In fact, almost half of U.S. adults don’t have enough put away to cover a surprise $1,000 expense. You may be one of them, with significant balances on credit cards or personal loans and minimum monthly payments piling up. Maybe you’ve heard that you can turn your home’s rising market value into financial relief. One popular way is to use your home’s equity to secure a loan for debt consolidation.

While there’s no single approach to take for consolidating debt, a potential home value increase can give you even more flexibility toward your future. If this is the year you hope to clear those high-interest rate debts once and for all, a home equity option may be for you. Here are a few things you should know before reaching out to a lender to consolidate debt.

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What is debt consolidation, and should I consolidate?

Debt consolidation is the process of combining all of your smaller credit card debts or personal loan balances into one. Instead of managing three, four, or even five minimum payments (or more) to various lenders, you would make one big payment that covers all of them. This is typically done by borrowing money from a bank through a new loan and using the cash payout from that loan to pay off all of those smaller cards and personal loans.

Consolidation can be a great way to save money and be more organized.

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How does it work? 

If the interest rate on the new debt consolidation loan is lower than the rate you were paying on your credit card debts, you could save on annual interest.

Since you’ll only have one monthly payment to make each month, which has a potentially lower APR than the multiple credit cards or loans you were paying, you can see the savings add up. You are also less likely to miss a payment, rack up late fees, and go over the limit on charged-up cards. (These all can add to your high monthly payments and overall money woes.)

Debt consolidation won’t work for everyone, and it’s not enough to get approved for a loan to pay off debt. You must also commit to paying off expensive credit card debt or loans with the cash from your consolidation loan and keep it paid off. If you’re someone who can’t keep from spending on those cards again, you’ll end up with the card balances back up to the max while having to pay off a new monthly loan amount from your consolidation loan. That’s twice the debt burden!

Consolidation is best for those who have set money goals, have the discipline to keep the original card balances paid off, and budget for the larger consolidation loan payment each month.

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How do I consolidate my debt with a home equity loan?

Have you decided that you are the right kind of person to use a consolidation loan responsibly and use it to pay off those annoying credit card debts? Congrats! Many lenders offer a loan to pay off debt, but not all are created equally.

Home equity loans are a particular type of loan that uses the paid-off value of your home, also known as “equity.” Let’s say your home is worth $250,000, and you have paid off $150,000 of your mortgage. You should have around $100,000 in home equity. This is the amount of the home you own – not the bank – and can be used to secure a home equity loan.

Lenders differ in how much they’ll loan to pay off debt. The amount depends on the equity in your home. If a lender offers 80% to the value of your home equity, for example, you could qualify for $80,000 on that $100,000 in home equity. After the lender approves your loan, they’ll release the funds to you. Then, you are free to use it to consolidate debt.

Home equity loans don’t always specify how you can use the money. So, you could use it to pay down debt or get rid of other costly expenses – like medical bills. Each program has different requirements, however.

FHA-approved lenders, for example, offer the Home Equity Conversion Mortgage (HECM), the only reverse mortgage insured by the government. You can use the loan to purchase a primary residence, in addition to supplementing retirement income or paying costly debts.

Others use the money for in-home care services, as an alternative to a retirement home. As long as the loan requirements are met, including keeping up on property taxes and homeowners insurance, the proceeds are flexible to the needs of the borrower.

Some borrowers choose to make home repairs, getting an additional tax benefit on the interest paid on their loan.

How should you use the loan proceeds? It’s up to you. Loan consolidation is just one of the popular uses for this service.

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Home equity loan or HELOC to consolidate debt?

The terms “home equity loan” and “HELOC” get thrown around, and some people use them interchangeably. They aren’t the same thing, however. While a home equity loan is a standard loan with set minimum monthly payments and a specific loan length, HELOC works differently.

HELOC stands for “Home Equity Line of Credit.” It may have the same application and approval process as a home equity personal loan, including assessing your home’s value and looking at how much you own on your mortgage. When the bank approves you, it uses your home as collateral for a second loan, not a second mortgage. You generally get a single large payout, but as you pay it back, you get access to that paid-off portion of the original loan amount as a credit line that you can borrow against again and again. It is considered a revolving credit account, not an installment loan.

HELOC users like that, after they start paying down the original loan amount, they can borrow $50 or $5,000, then pay it back as needed during the draw period. The borrower can choose to pay early, access this credit as required, or pay off the total amount at the end of the loan term.

One drawback to the HELOC is that interest tends to be variable, so today’s low rate may not be so low next year or the year after that. Market influences cause the debt to be more affordable or more expensive; home equity lines of credit are generally fixed-rate loans.

A few HELOC service providers are making strides to limit the surprises of a variable rate loan; however, set rate limits ensure that even variable rates don’t go above a certain amount (helping you plan for those times of market volatility.)

Whether you choose a home equity loan or a HELOC to consolidate debt depends on your money needs.

• Do you want the flexibility to take out cash when needed, over and over? HELOC may be your best bet.
• Do you prefer a one-time lump sum payment that you can pay back predictably over many years? A home equity loan could be a better pick.
  

Your needs may change over time, as well. You can always use a HELOC to take out a large sum and pay it back according to your plan. A home equity loan is generally “all or nothing.” If you get approved for $100,000, for example, borrowers are given the entire $100,000 amount upfront with the expectation to make repayments immediately. How much money you need and your repayment abilities can help shape which one you ultimately pick.

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Additional HELOC and home equity loan considerations

Remember, both of these loan products use your home’s equity as a guarantee that you’ll repay the bank. If you’ve paid off $100,000 of your mortgage, then use that equity to secure a loan, failure to repay could put your home at risk of foreclosure. Fortunately, responsible lenders are educating borrowers before they sign on the dotted line. 

Be sure to ask questions before starting the process and avoid any lender who is reluctant to tell you the truth about what you are getting into. You should still look into ways to consolidate debt, but don’t rush into anything.

How do I get a home equity loan to consolidate my debt? 

Because a home equity loan uses your home as collateral, additional paperwork is required to demonstrate the value of your home. Expect to have your home appraised and be ready to fill out more paperwork than an unsecured personal loan or credit card. In most cases, you will provide proof of income and employment history, but if you’ve applied for a mortgage in the past, the process is similar.

It may go without saying, before a lender can give you another loan to pay off debt, they need to see that you are already making on-time mortgage payments. Your mortgage account must be in good standing. From there, they run credit checks and ensure application info is accurate. You’ll learn about any origination or other fees for the loan service. (Most large personal loans have these.)

Approval may take a few weeks or longer, depending on the lender’s process and if they ask for any follow-up documentation. The process involves a good amount of paperwork, but you’ll receive funds in a lump sum for home equity loans once completed. HELOC varies slightly, but the credit line is yours to use once approved. Will you use it for credit card debt? Maybe you’ll decide to finance home improvements. How and how much you choose to spend is up to you and your budget plans.‍

Are you looking for a loan to pay off debt? Fraction keeps the process simple and can get you well on your way to consolidating debt and setting new financial goals. Reach out today.