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Sometimes it actually does make sense to put all of your eggs in one basket.
Consolidating your debt can help you streamline your repayment plan — and hopefully save you money in the long run. But when you’re using your home as collateral to secure your existing debt, there are a few more factors to consider — starting with the fact that a failure to repay could end up costing you your house.
How to Consolidate Debt Using Your Home’s Equity
Debt can pile up fast, and you may find yourself facing multiple payments per month on things like your mortgage, credit cards, and student loans.
“Most consumers are dealing with some type of unsecured debt, and COVID has definitely made it more difficult to handle,” says Jeffrey Arevalo, a financial wellness expert at GreenPath Financial Wellness.
Consolidating your debt means taking out one big loan and using it to pay off your other existing debt. That way, you’ll only have one loan payment to meet every month, ideally with a lower interest rate on that single loan than what you have on your existing other loans.
For example, if your credit card is charging you 16% interest on your lingering credit card debt, and you consolidate that loan into a home equity line of credit with a rate around 4%, then you’re going to save some serious money on interest.
“For someone struggling to pay their debt repayments, not making fast enough progress, paying high interest rates, or they’re just overwhelmed, I would consider debt consolidation,” says Arevalo.
For those who have a decent amount of equity in their home, a home equity loan or home equity line of credit (HELOC) can be good tools to consider — if you can qualify for one. Home equity lending has tightened in the last year, making it more difficult to obtain these loans if you have a lower credit score and less equity in your home.
A home equity loan is similar to a traditional loan: you’ll get a lump sum at the beginning of your term, then have monthly payments (plus interest) until you pay off what you borrowed. A home equity line of credit is more similar to a credit card. It’s a revolving line of credit, meaning you choose how much you spend on the line as you go, and then have a repayment period to pay off what you borrowed (plus interest).
Is It a Good Idea to Use Home Equity to Consolidate Debt?
You should seriously consider your repayment plan and if the underlying behaviors that led to your debt in the first place are going to continue before taking out a home equity loan or line of credit for debt consolidation.
“You want to be so careful about turning unsecured debt into secured debt,” Arevalo says. “If you were to default on a home equity loan or home equity line of credit, you could risk things like foreclosure.”
Yes, you risk losing your home if you don’t make your payments.
“I think it’s a dangerous world to borrow from your house to pay off your credit cards, because quite often we don’t change our behavior. We just wind up putting all of our piles of debt into one massive pile,” says Craig Lemoine, the director of the Academy for Home Equity in Financial Planning at the University of Illinois.
But if you do it correctly, and make diligent payments, then it can be a way to save money on your debt repayment.
Taking high-interest loans and consolidating them into a HELOC or home equity loan, “could potentially save you thousands of dollars a month,” says Darren Q. English, a development loan officer at Quontic.
Again, just make sure that you’ve addressed the underlying circumstances that led to your debt in the first place.
“If it turns out they can save a lot more money on interest, and they’re OK with turning unsecured debt into secured debt, that’s when a home equity loan would make sense,” Arevalo says. “But any behaviors or circumstances that led to the debt being accumulated in the first place need to be addressed.”
You’ll want to take a holistic approach to your situation to know if this strategy makes sense. Think about all of your income and all of your debts, what other regular bills you pay, and your cash flow.
“Sometimes getting a loan or consolidation is not going to solve that underlying issue. It could just be Band-Aid,” says Arevalo.
Home Equity Loan vs. HELOC for Debt Consolidation
The principles of using either product for debt consolidation are the same: you’ll take out your HELOC or home equity loan, use it to pay off existing debt, then only have that one existing loan to worry about.
A home equity loan is a more-structured, traditional loan. You’ll take out a lump sum, against your home, and usually consumers can use it to knock out their debts “fairly quickly,” according to Arevalo.
You’ll have a fixed interest rate for a home equity loan. That means you’ll lock in your interest rate at the beginning of your loan term and it won’t change.
A HELOC, on the other hand, offers a bit more flexibility. It’s similar to a credit card, and therefore your payments will be variable based on how much you spend on your line. Your interest rate will also be variable with a home equity loan, meaning if rates rise you’ll be subject to higher interest payments.
With a home equity loan in particular, it’s more likely that you’ll have to pay closing costs and get an appraisal on your home, though some lenders require the same measures for HELOCs. These will be out-of-pocket expenses.
Pros and Cons of Using Home Equity for Debt Consolidation
Consolidate multiple debts into a single payment
Save money on interest
Streamline repayment (one payment to worry about, instead of many)
Turning unsecured debt into secured debt
Could lose your home if you fail to make your payments
May not qualify for an ideal interest rate
Need to have good credit and decent amount of home equity to qualify for a home equity loan
Alternative Debt Consolidation Options
If you’re considering debt consolidation, but are not sure if it’s right for you, reach out to a free counseling agency that can help you with your decision.
If you’re wary of turning your unsecured debt into secured debt, a balance transfer credit card might make sense. You may also be able to get a personal loan depending on how much debt you need to pay off. Both these options come with their own set of pros and cons, so do your research before diving in.
Whatever you choose to do, just “be careful that you’re not just shifting your debt around to different places instead of dealing with it head-on,” Arevalo says.