Why Should You Consider Home Equity Loan for Debt Consolidation?

In 2023, the average American household held $104,215 in debt. Shockingly, 66% of people considered bankruptcy to manage this debt. This financial strain is stressful and hard to handle. However, you can manage your debts effectively with a home equity loan for debt consolidation.

By using the equity built up in your home, you can streamline your debts and potentially reduce your monthly payments. In fact, over 42% of borrowers have already used debt consolidation to decrease the total amount of debt they owe.

If you plan to use your home equity to consolidate debt with a loan or line of credit, you need to find the best interest rates and terms. Check out different loan options with Houzeo to find one that fits your needs.

What Is a Home Equity Loan?

A home equity loan lets you borrow money using the equity in your home. Equity is the portion of your home’s value that you own. It is the difference between your home’s current market value and the amount you owe on your mortgage.

As you make monthly mortgage payments, the amount you owe gets smaller. At the same time, if your home’s value goes up, your home equity grows. For example, if your home is worth $300,000 and you owe $200,000, your equity is $100,000.

You can borrow against this $100,000 equity with a home equity loan. Lenders let you borrow up to 80-85% of your equity amount. So, in this example, you could get a loan for $80,000-$85,000.

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

A Home Equity Line of Credit (HELOC) is another way to access your home’s equity. It works like a credit card backed by your home’s value. With a HELOC, the lender sets a credit limit based on how much equity you have in your home. You can borrow up to 85% of it.

Unlike a home equity loan, a HELOC lets you borrow money as you need it, up to a set limit. You only pay interest on the amount you use.

How Does Home Equity Debt Consolidation Work?

Here’s a step-by-step look at how the process works:

1. Determine Your Home Equity Amount

The first step is calculating how much equity you have available in your home. Lenders determine this by getting a professional appraisal of your home’s current market value.

You can estimate your home equity with Houzeo’s most accurate home value estimator. This is free and online, giving you an estimated home market value

2. Apply for a Home Equity Loan or HELOC

You’ll then need to choose whether a home equity loan or a HELOC better suits your needs. Most lenders allow you to borrow up to 80-85% of your home’s equity value.

3. Use Funds to Pay Off Debts

If approved, your lender provides you with a credit limit. You can then use those funds to completely pay off balances from debts you want to consolidate.

4. Make One Monthly Payment 

Instead of multiple payments to various creditors every month, you’ll now make a single payment towards your new home equity loan or HELOC balance. These have much lower interest rates compared to other consumer debt.

5. Pay Off Remaining Balance

Continue making the scheduled payments each month until the home equity loan balance is fully paid off. HELOCs may allow interest-only payments initially during the draw period.

How to Qualify for Home Equity Debt Consolidation

To qualify for a home equity loan or HELOC for debt consolidation, you need to meet certain criteria:

1. Home Equity Amount: You’ll need to have built up sufficient equity in your home to borrow against. Most lenders require you to maintain at least 15-20% equity even after taking out the new loan.
2. Credit Score: Your credit score plays a major role. Most lenders look for a FICO score of 620 or higher. It shows you’ve responsibly managed credit in the past.
3. Debt-to-Income Ratio (DTI): Lenders check your debt-to-income ratio – the percentage of your gross monthly income that goes towards recurring debts. A DTI under 43% substantially improves your chances.
4. Loan-to-Value Ratio: This ratio compares the loan amount to your home’s appraised value. Lenders cap loan-to-value ratio at 80-85% to ensure you maintain an equity stake in the property.

How to Apply for a Home Equity Debt Consolidation Loan?

Here are the steps to follow once you have decided to use a home equity loan to consolidate your debt:

1. Gather Required Documentation

Lenders will need various documents to evaluate your application, such as:

• Proof of income (pay stubs, tax returns, etc.)
• Bank statements
• Information on existing debts and credit accounts
• A home appraisal or estimate of fair market value

Having these documents ready in advance can help speed up the process.

2. Evaluate Lenders and Rates

Research multiple mortgage lenders to compare interest rates, fees, and loan terms. Look for competitive rates and repayment periods that fit your budget. 

3. Complete the Application

Once you’ve selected a lender, complete the formal application process. This involves providing personal information, employment details, and specifics about your home and existing mortgage.

4. Home Appraisal

Depending on the lender’s policies, you may need to have a home appraisal to determine its current market value. This helps establish how much equity you have available to borrow against.

5. Underwriting and Approval

The lender will review your application, credit history, income, debts, and home equity to determine if you qualify for the loan. If approved, they’ll provide the loan terms and closing details.

6. Loan Closing and Disbursement

At closing, you’ll sign the loan agreement and any other required documents. Once complete, the lender will disburse the funds, which you can then use to pay off your outstanding debts.

Pros and Cons of Using Home Equity Consolidation Loan

While using a home equity loan or HELOC can be an effective way to consolidate debt, it’s crucial to understand its pros and cons: 

Pros

1. Lower Interest Rates: You can access funds at a much lower interest rate than credit cards or personal loans. Lenders view the loan as less risky since your home secures it, resulting in more favorable rates.

2. Tax-Deductible Interest: The interest paid on a home equity loan or HELOC can be tax-deductible if the funds are used for home improvements or other qualified purposes.

3. Simplified Monthly Payments: You can streamline multiple debts into one convenient monthly payment by consolidating them into a single loan. This simplifies budgeting and debt management.

Cons

1. Risk of Foreclosure: Using your home as collateral means missing payments could lead to foreclosure. You could lose your home, so budget carefully and maintain a steady income.

2. Closing Costs and Fees: Like mortgages, home equity loans and HELOCs often have closing costs, origination fees, etc. These upfront expenses add to the total cost of borrowing.

3. Reduced Home Equity: Tapping into your home’s equity, means borrowing against the portion you own outright. This reduces the equity available for future needs or emergencies.

Alternatives to Home Equity Loan Debt Consolidation

Using home equity to pay off debt can be an effective way, but it may not be the best fit for everyone. There are other alternatives and it’s essential to explore them before making a decision.

1. Cash-Out Refinance

A cash-out refinance involves refinancing your existing mortgage for an amount higher than your outstanding balance. The difference between the new mortgage and the old one is given to you in cash, which you can use to pay off debts.

2. Personal Loans

Personal loans from banks or online lenders can be an excellent alternative for debt consolidation. They offer lower interest rates than credit cards and can be obtained without using your home as collateral. 

3. Balance Transfer Credit Cards

If you have good credit, you may qualify for a balance transfer credit card with a low or 0% introductory APR (Annual Percentage Rate). These cards allow you to transfer your existing credit card balances and pay them off over a set period, at a lower interest rate. 

4. Debt Management Plans

A debt management plan is a program offered by credit counseling agencies. They negotiate with your creditors to reduce interest rates and fees. You make a single monthly payment to the agency, which then distributes the funds to your creditors. 

Bottom Line

Using a home equity loan to consolidate debt can help you manage what you owe more easily. By using your home’s equity, you can get lower interest rates and simplify your monthly payments.

However, it’s important to weigh the pros and cons, explore different loan options, and make sure this plan works for your finances. Consulting with a mortgage lender can help you find the right loan for your needs.

Frequently Asked Questions

• Home Equity