Should I Use Home Equity to Pay Off Debt?

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Homeowners might consider tapping into home equity to pay off other debt, but is it a good idea?

Thanks to rising home prices, the average homeowner’s equity increased by $64,000 between Q1 2021 and Q1 2022, according to CoreLogic data. If you want to turn that equity into cash to pay off debt, taking out a home equity loan or home equity line of credit (HELOC) are options to consider. Read on to learn how home equity loans and HELOCs work and the pros and cons of using them.

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What Is a Home Equity Loan and Home Equity Line of Credit (HELOC)?

A home equity loan, also called a second mortgage, is an installment loan product that usually has a fixed interest rate and offers a loan repayment term ranging from five to 30 years. With home equity loans, you get a lump sum of cash after you’re approved, which you can use to pay off other debt.

A HELOC is a credit line that’s backed by your home. With a HELOC, you get a credit limit that you can draw from as you need cash. Typically, interest rates on HELOCs are variable like a credit card, so the rate can increase if market rates fluctuate.

HELOCs might also have a draw period where you can take money from the credit line. That’s followed by a repayment period where you can no longer draw funds, and you have to pay back what you borrowed.

Benefits and Risks of Consolidating Debt With Home Equity

The main benefit of HELOCs and home equity loans is that interest might be lower than unsecured personal loans and credit cards. If you consolidate high-interest debt with a low-interest home equity product, your new payments might be lower, and you might be able to pay off debt faster.

That said, there are some disadvantages to taking equity out of your home, and the main one is that the loan is secured by your house. If you don’t make mortgage or home equity loan payments, your home could go into foreclosure.

In contrast, lenders don’t put a lien against your home for unsecured loans, so you might take a credit hit, but you don’t have to worry about foreclosure if you default on unsecured debt. (Although, debt collectors could sue you, and in that case, further action could be taken to collect.)

Another major risk of borrowing from equity is that you could end up underwater if the value of your home drops and the balance of your mortgage and home equity loan exceeds what the home is worth.

If you sell your home, you’ll have to pay the home equity loan or HELOC back with the proceeds from the home sale, netting you less profit. And taking out a home equity loan typically comes with closing costs, such as appraisal, origination, and application fees.

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Factors to Consider Before Consolidating Debt With Equity

Before paying off debt with a home equity loan or HELOC, these are factors to consider for each type of debt:

Credit card debt credit_card

Using a home equity product to pay off a high-interest credit card could save you quite a bit of interest. According to the Federal Reserve, the average credit card interest rate for cards assessed interest is 16.65% APR. In comparison, the average home equity loan rate is just 5.96%, and the average interest rate for a home equity line of credit is 4.27%, according to Bankrate.com.

However, another better way to reduce credit card interest could be transferring your balance using a balance transfer credit card that offers a 0% APR special for a certain number of months. If you split your balance into equal credit card payments during the promotional period, you could pay off your debt interest-free.

Student loan debt student

Whether it makes sense to pay off student loans with a home equity product depends on your loan type. Federal student loans offer low-interest rates and borrower benefits like income-driven repayment (IDR) plans, loan forgiveness programs, and forbearance or deferment options if you’re facing financial hardship or you go back to school.

Home equity products don’t offer the same perks, and consolidating with a home equity loan or HELOC would give up these benefits. In most cases, it’ll make more sense to keep your federal student loans as is. And if you want to consolidate them for easier repayment, you could consider the federal Direct Loan Consolidation program.

However, private student loans from private lenders might come with higher interest rates and fewer perks than federal student loans. Borrowing from home equity to pay off private loans could lower the cost, extend your repayment term, and make payments more manageable.

Although, many private lenders can help you achieve these same goals with student loan refinancing. If you have questions about refinancing or concerns about making payments, reaching out to your student loan lender for payment relief options might be a better move than tapping into your home equity.

Personal loans moneybag

Interest rates and terms on personal loans can vary widely based on your credit and the lender you borrowed from. The average rate on a 24-month personal loan is 8.73% APR, according to the Fed, but some lenders might offer up to 36% APR for installment loans depending on your credit.

Interest rates for short-term payday loans can even go past 300% APR, which is exponentially higher than what you might receive on a home equity loan. In a scenario where a home equity product will provide you with significant savings, paying off personal loans with home equity could make sense.

Auto loans oncoming_automobile

Like home equity products, auto loans are secured by an asset, which is your car. If you pay off your auto loan with home equity, you could get your title faster. Just be mindful that using a home equity loan with a very long loan term could result in your car depreciating faster than you pay off your loan. This could mean you’ll end up upside down on the car, owing more than what it’s worth over time.

If you’re unhappy with your auto loan terms, refinancing could be another option. Auto loan refinancing is taking out a new loan to replace your existing loan, and you might qualify for a better interest rate if your credit score is stronger today than when you initially borrowed. At a marketplace like RateGenius, you can fill out one form and shop for auto loan refinancing offers from multiple lenders.

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How to Qualify for a Home Equity Loan or HELOC

If you decide to take out a home equity loan or HELOC, qualifying comes down to three factors — your home equity, debt-to-income (DTI) ratio, and credit. Here’s a breakdown of the eligibility criteria:

Equity

Home equity is calculated by subtracting your loan’s balance from your home’s market value. For example, if your home is worth $400,000 and your home loan balance is $275,000, your equity would be $125,000. This number represents the part of the home that you own outright and what you might be able to borrow from.

Lenders generally let you borrow up to 85% of the home equity you’ve built up. However, the amount you can borrow will depend on how much home equity you have. If you just recently purchased the home or bought the home with a low down payment, your equity might not be high enough to qualify.

Debt-to-income (DTI) ratio

Your DTI ratio is the percentage of your monthly income that goes to making debt payments each month. You can calculate your DTI by adding up your monthly debt payments, dividing that number by your gross monthly income, and multiplying by 100. The calculator below can help you do the math.

(DTI) Debt-to-Income Ratio Calculator

What is your monthly income?
What's your total monthly debt payments?

DTI requirements can vary by lender, but generally, lenders like to see that you have a DTI below 43%.

Credit

The higher your credit score, the better your chances of getting approved for a home equity loan or HELOC. On the FICO Score scale, 620 could be enough to qualify, but having a score of 740 or higher puts you in the “very good” credit range and could make you eligible for lower interest rates.

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Should You Use Home Equity to Pay Off Debt?

Whether it makes sense to borrow from home equity to pay off debt depends on how much you’d be able to save with the interest rate cut and how confident you are that you’ll be able to keep up with payments. If you’re struggling financially, borrowing from equity and having trouble with payments can make a bad situation even worse. Here are other tactics to pay off debt:

  • Create a budget. A budget can help you keep better track of your money, and allocating a higher percentage of your income to debt could help you eliminate it faster.
  • Negotiate lower rates. In some cases, you might be able to negotiate lower rates with your credit card issuer, and refinancing your loan could improve your loan terms.
  • Choose a debt repayment strategy. The debt snowball and debt avalanche are two popular debt repayment strategies that help you decide which debt to pay off first. The debt snowball is where you focus on the smallest balances first, and the debt avalanche is when you pay off your most expensive debt first.
  • Get on a debt management plan (DMP). Some credit counseling companies offer DMPs where a credit counselor tries to negotiate better interest rates on your debt. Afterward, they create a payment plan and manage your payments for a small fee.
  • Negotiate a settlement. A debt settlement is when you negotiate to pay a lower amount to settle your debt. A creditor might be willing to accept less money than what you owe as a last-ditch effort to collect. But, a debt settlement can negatively affect your credit score, which is something to consider before negotiating an agreement.

Borrowing from home equity is a loan you have to pay back, and the consequences of not paying are high. If you’re able to pay off debt without pulling from home equity, your equity can continue to grow untouched, which could result in you seeing a bigger payday when it’s time to sell.

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About The Author


Taylor K. Medine

Taylor K. Medine is a personal finance writer covering money management topics and finance products. She's written for finance publications such as Credit Karma, CompareCards, and MagnifyMoney. She runs the blog TayTalksMoney, which discusses how Millennials and Generation Z can live an abundant life on a tight budget.


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