Should you use a home equity loan to pay off your debts?

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Home equity loans generally have relatively low interest rates, especially compared to unsecured forms of debt like credit cards. If you’re one of the millions of Americans struggling with consumer debt, taking out a home equity loan to pay off your higher-interest debt can be a great option.

Key points to remember

  • Consolidating higher-interest debt from a credit card or personal loan to a lower-interest home equity loan can help you pay off your debt faster and for less. money overall.
  • If you can’t make the payments on your home loan, you could lose your home to foreclosure.
  • If the value of your home drops below your mortgage and mortgage balance, you may not be able to sell your home or move.
  • Be sure to address the causes of your high-interest debt so you don’t get trapped in a cycle of mortgage debt.

Advantages and Disadvantages of Using a Home Equity Loan to Pay Off Debt

Interest rate comparison

The median credit card interest rate in May 2022 is 19.62%. The published annual percentage rate (APR) on a 10-year home loan through US Bank was 4.75% during the same period.

Advantages

Home equity loan interest rates are significantly lower than many other types of debt. If you can only pay a fixed amount each month to pay off your debts, taking out a home equity loan to pay off your loan balance can help you settle your debts faster. A lower interest rate means that more of your monthly payment is used to pay down the principal each month. From a purely financial standpoint, paying off your higher interest debt with a low interest home equity loan will save you the most money in the long run.

The inconvenients

There are several drawbacks to using a home equity loan to pay off debt that should not be ignored. Although you may intend to use your home equity loan to settle your debts, you may find yourself using your lump sum frivolously and finding yourself in even more debt. If you use your home equity loan to settle your debt and find yourself unable to repay your home equity loan, you could lose your home to foreclosure. While defaulting on your unsecured debt can hurt your credit for years, defaulting on your home equity loan will hurt your credit and leave you homeless.

Even if you use your home equity loan responsibly and make payments every month, you could find yourself under water on your loans if your home’s value goes down. In this situation, you may be unable to move or sell your home for years while you pay off your loans or wait for the value of your home to increase.

Behavioral changes

Consolidating higher-interest debt into a low-interest home equity loan may be the smartest thing from a mathematical standpoint, but don’t ignore the emotional and behavioral concerns. Daniel Yerger, certified financial planner and owner of MY Wealth Planners, warns that “consolidating high-interest debt into a home equity loan can be a great money-saving technique, but it doesn’t is only useful if the underlying cause of the original debt is addressed. ”

If you have a high consumer debt balance and are using a home equity loan to pay it off, be sure to address the causes of your high balance so you don’t find yourself in the same situation for a few months or years. later. . Consider downloading a budgeting app to track expenses and make sure you’re using the money for things you really enjoy. Be sure to accumulate savings in an emergency fund so you don’t accumulate balances on high-interest credit cards if something goes wrong.

What is debt consolidation?

Debt consolidation consists of taking out a new loan to repay other loans. Taking out a home equity loan to pay off older debts is a form of debt consolidation.

Do I need good credit for a home equity loan?

Although each lender’s requirements vary, you will generally need good credit to get approved for a home equity loan. Because home equity loans are secured using the equity in your home as collateral for the loan, you may be able to be approved for a home equity loan even if you do not qualify for an unsecured loan like a personal loan.

Can I get approved for a home equity loan if I have a lot of credit card debt?

Yes, you can get approved for a home equity loan even with a lot of credit card debt as long as your income is high enough and you have enough equity in your home. Lenders look at several factors when applying for a home equity loan. They will generally want a combined loan-to-value (CLTV) ratio of 85% or less. This means that your mortgage balance plus home equity loan balance divided by the value of your home equals less than 85%.

In addition to CLTV, they will consider your debt-to-income ratio (DTI). Your DTI is the total of your monthly debt payments divided by your gross monthly income. Most lenders prefer your DTI to be 36% or less.

The essential

Consolidating higher-interest debt into a low-interest home equity loan can help you pay off your debt faster and at a lower cost. Make sure you fully understand the risks of a home equity loan before you sign up for a loan, and set yourself up for future success by taking care of your financial habits first.

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