Using A Home Equity Loan For Debt Consolidation
What is a home equity loan for debt consolidation? If you have debt to pay off, consider getting a loan to access your home equity, or the amount of your home you currently own. Put simply, consolidation means that you use one loan to pay off other loans, reducing the number of loans you pay and potentially decreasing your interest rate across your debt load.
You can use a home equity loan or a home equity line of credit (HELOC) for debt consolidation. Keep reading to find out whether a home equity loan will work for you.
What Is A Home Equity Loan?
A home equity loan is a second mortgage that allows you to borrow money, just like your original mortgage. However, in this case, the lump sum amount you can borrow from your lender depends on the amount of equity you have in your home.
Your ability to get a home equity loan is also based on your credit score. It’s a good idea to shoot for a 620 credit score or higher. Also put a debt-to-income ratio (DTI) of 45% or lower on your radar.
Your credit score is a three-digit number that tells your lender how well you handle debt and helps your lender determine whether you will qualify for a home equity loan. DTI refers to the amount of debt you have relative to your income. You can calculate DTI by adding up your fixed monthly debts and dividing by your gross monthly income.
You’ll start repayment in fixed installments over a certain period of time. Your interest rate and payment remain the same throughout the loan term. You’ll have two loan payments: your original mortgage and a second mortgage payment.
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What Is A Home Equity Line Of Credit (HELOC)?
A home equity line of credit (HELOC) is another way you can dip into your home equity for debt consolidation. In this case, a HELOC for debt consolidation is a line of credit that offers flexibility. You can withdraw money from your lender on a revolving basis like a credit card based on the available equity in your home. You can pull the amount you need to borrow throughout a draw period.
That’s the main difference between a HELOC and a home equity loan, which you receive in a lump sum. Another major difference between home equity loans and HELOCs has to do with interest rate. HELOCs have variable interest rates (variable rates change) instead of fixed interest rates (which stay the same).
At the end of your draw period, you’ll repay your loans based on an established repayment period.
Lenders will also take your credit score and DTI into account to qualify for a HELOC. While requirements can vary by lender, you’ll want a credit score above the mid-600s, with an ideal credit score of above 700. The higher your score, the more money you can borrow and the more favorable your rate can be.
Using A Home Equity Loan To Consolidate Debt
Let’s take a look at an example, knowing that Rocket Mortgage® allows borrowers with a high credit score to borrow around 90% of the equity in their homes.
Kristen wants to consolidate her student loans and credit card debt.
First, she figures out how much of her home equity she can tap into by determining her loan-to-value ratio (LTV). She calculates her LTV by subtracting the remaining balance of her primary mortgage from 90% of the appraised value of her home. In this case, Kristen’s home is appraised for $300,000 and her remaining mortgage balance is currently $150,000.
$300,000 x .9 = $270,000
$270,000 - $150,000 = $120,000
In this example, Kristen may be able to borrow $120,000 to consolidate her debt.
Then, she must decide whether she wants a home equity loan or a HELOC. In this case, she decides to go for a home equity loan based on the type of loans she has – student loans and credit card debt. A lump sum will help her take care of her student loans in one swoop.
If she wanted to consolidate debt, but also use funds to renovate, a HELOC would be a good option because she could spend the money as needed.
How To Get A Home Equity Loan For Debt Consolidation
How do you obtain a home equity loan for debt consolidation? Let’s take a look at a quick step-by-step list.
- Apply for a home equity loan. Your lender will need to take a look at your existing home equity, credit score and debt-to-income ratio (DTI).
- Pay closing costs. Note that you’ll have to pay closing costs (the fees to process your loan) for both HELOCs and home equity loans and the exact amount depends on your area and loan type. Ask your lender for more information about closing costs.
- Get a home appraisal. Your lender will call for an appraisal, which means either a professional appraiser or a computer-generated appraisal determines the fair market value of your home.
- Repay your loan. Once you receive your lump sum (for a home equity loan) or end your draw period (for a HELOC), you’ll make repayments. During the draw period on a HELOC, you’ll make interest payments. Once you end your draw period, you’ll repay based on principal and remaining interest.
The Pros And Cons Of Using Home Equity To Pay Off Debt
There are advantages and disadvantages to using home equity to pay off debt. Let’s go over the pros and cons.
- Your payments will be simplified. Consolidating debt condenses your monthly payments into one, making it easier to keep track of and pay off.
- You’ll have a lower interest rate. Home equity loans tend to come with lower interest rates since a home is put up for collateral.
- Your monthly payments will be lower. Home equity loans usually offer a lower interest rate and longer loan term, therefore making the monthly payments lower.
- Your home is put up as collateral. It’s important to remember that because homeowners put their homes up as collateral, they could lose them if they stop making their payments.
- You may have to pay additional fees. Borrowers might have to pay additional fees (appraisals, closing costs, etc.) since you will use your home’s value to calculate what you can borrow.
- Your home value could change. If your home value ever decreases, you could end up owing more.
Other Ways To Consolidate Debt
There are different ways borrowers can consolidate debt besides tapping into home equity loans: cash-out refinancing, personal loans, balance transfer credit cards and 401(k) loans.
A cash-out refinance doesn’t give you another loan like a home equity loan. It replaces your existing loan. You simply refinance for more than what you have to pay on your loan and take the difference in a lump sum.
In other words, let’s say you have $130,000 to pay off on your mortgage. You can refinance for $140,000 and take the difference – $10,000 – to consolidate your loans as long as you have sufficient equity in your home.
A personal loan can help you consolidate debt by applying one loan to pay off many loans all at once. A personal loan is a type of loan that doesn’t require collateral. However, it’s important to note that personal loans may not have a lower interest rate compared to other types of loans.
Balance Transfer Credit Cards
A balance transfer credit card is a type of credit card that allows you to transfer debt from one account to another, including several credit cards to one, which can help you handle credit card debt.
A 401(k) loan allows you to borrow money from your 401(k). The intent is that you’ll pay yourself back later within 5 years. You can borrow $50,000 maximum or 50% of your vested account balance (whichever is less). If you don’t pay your balance within the 5-year requirement, your loan could end up costing you in the form of taxes and penalties.
The Bottom Line: A Debt Consolidation Home Equity Loan Can Provide Relief
A debt consolidation home equity loan or a home equity debt consolidation loan could offer the solution you need to pay off your existing debt.
Before you apply, make sure you meet the credit score and DTI guidelines in order to qualify. Make sure that you also understand the pros and cons of both types of loans, including that if you stop making your payments, your lender could take your home from you.
Get started on a home equity loan if you think it’s the right option for you.