Taking out a home equity loan to pay off debt: A smart solution or risky move?
In a financially demanding world, it’s common for many individuals to find themselves burdened with high-interest debts. One potential solution for tackling these debts that’s available to homeowners is taking out a home equity loan. This type of loan allows you to unlock value stored in your property and turn it into cash that you can use to consolidate or pay off other forms of debt. However, before jumping into this opportunity, you should understand what home equity loans are, how they can be used to pay off debts, and the benefits and risks associated with them.
What are home equity loans?
Homeowners can take out home equity loans using their property’s equity as collateral. Because these loans are secured by your home and often taken out in addition to a primary mortgage, they are commonly referred to as second mortgages. This also means that home equity loans often come with lower interest rates than alternatives like personal loans or credit cards.
The equity in your home is the difference between its current value and the balance of any existing mortgages held for the property. The amount that you can borrow from your equity depends on criteria set by your lender and any applicable state or local laws that set limits on the maximum percentage of your home’s value that may be mortgaged.
There are a few financing options that allow you borrow from your equity. These include home equity lines of credit (HELOCs), cash out refinances, and traditional home equity loans. HELOCs are structured differently from traditional home equity loans, and cash out refinances require refinancing your existing mortgage to pull additional funds from your equity in the process.
In contrast, home equity loans typically have fixed interest rates and fixed repayment terms without requiring a mortgage refinance. This makes monthly payments predictable and potentially more manageable for borrowers.
Examples of using a home equity loan to pay off debt
- Consolidating high-interest credit card debt: Let’s say you have accumulated significant credit card debt at high interest rates. By taking out a home equity loan, you can use the funds to pay off all your credit card balances at once. This allows you to consolidate multiple debts into a single loan with a potentially much lower interest rate and a more manageable monthly payment. The money that you may save monthly by doing this could allow you to make additional payments on the principal of the home equity loan and ultimately eliminate your debt burden faster.
- Renovating your home and paying off other debts: Imagine you own a home with a large amount of equity and have other outstanding debts, such as student loans or a car loan. Instead of taking out a home equity loan that will just cover the cost of anticipated home repairs or upcoming renovations, you may be able to take out an amount to fund home improvements and pay off these other debts. By using the loan proceeds strategically, you can upgrade your living space while simultaneously reducing your debt load.
Benefits of using home equity to pay off debt
- Lower interest rates: Home equity loans typically offer lower interest rates compared to borrowing options that aren’t secured using collateral, such as credit cards and personal loans. With lower rates available, it may make sense to borrow from your equity to consolidate any unsecured debt balances you may have. This can potentially save you money on overall interest payments.
- Fixed repayment terms: With a home equity loan, you’ll know exactly how much you need to repay each month and for how long. This predictability may help you plan your budget more effectively.
- Higher borrowing limits: Compared to other borrowing options, these loans may help you withdraw more money, depending on the amount of equity you have available and your lender’s loan limits. This opens the possibility of using a single loan to consolidate debts, improve your home, and pay for other large expenses.
- Longer loan terms: Often coming with a term somewhere between 10-30 years depending on your lender and loan product, a home equity loan repayment plan may spread out over more time when compared to other financing options. This may give you a lower monthly payment and allow you to create more space in your budget.
Risks of using a home equity loan to pay off debt
- Risk of foreclosure: By using your home as collateral, there is a risk of losing your property if you default on loan payments.
- Increased debt load: With the opportunity to access higher loan limits and larger loan amounts, you might be tempted to take on more debt than you originally intended.
- Fluctuating property values: If the value of your property decreases in the future, you might end up owing more on your combined mortgage and home equity loan balances than your home is worth.
- Paying more in overall interest: By combining your debt balances into a single loan and stretching payments out across a repayment term of up to 30 years, there is a risk that you may wind up paying more in interest charges over the life of the loan than you would without it. To avoid this situation, make sure to compare the different available options so you can get the type of loan that works best for you.
Closing thoughts: Using your home equity to pay off debt
Using a home equity loan to pay off debt may be an effective strategy for homeowners with enough equity built up in their homes and when they can get offers for competitive interest rates. However, it’s essential to carefully consider the benefits and risks associated with this decision. Compare lenders, research products, and run the numbers on debt consolidation opportunities before proceeding to ensure that a home equity loan aligns with your long-term financial goals.