According to a recent survey from Freedom Debt Relief, 59% of homeowners believe that owning a home is part of the American dream. Not only do many Americans pour all of their savings into their home, they also make big financial sacrifices to keep their dream of owning a home alive.
Owning a home isn’t just about having a roof over your head—your home is where you can feel most comfortable and secure. It’s a place to call your own. So if you’re stuck in debt, you may be understandably hesitant to use the equity in your home to get that debt paid off, since it may put your home at risk.
Using a home equity loan to pay off debt may seem like a less appealing option than taking out a debt consolidation loan or just continuing to make the minimum payments on your debt. But in certain situations, paying off debt with a home equity loan is a smart choice. In this article, we’ll explore the pros and cons of taking out a home equity loan to pay off debt and help you figure out if this is the right choice for you.
Pros and Cons of Using Home Equity Loans to Pay Off Debt
If you’ve owned your home for a while now, you may have built equity in your home. Equity is the value of a home beyond the current mortgage balance. For example, if you still owe $50,000 on your mortgage but your home is currently worth $200,000, you technically have $150,000 worth of equity in your home.
You can pull equity out of your home to consolidate and pay off high interest debt, pay for home renovations, or do almost anything else. And there are many different ways to draw equity out of your home, including home equity loans, home equity lines of credit, and cash-out refinancing.
If you’re thinking of taking out a home equity loan to pay off debt, you’re not alone. 34% of the homeowners we surveyed said that they have considered this option to help them deal with their debt. But before you take out a home equity loan to pay off debt, you should consider the pros and cons.
|Pros of using a home equity loan to pay off debt||Cons of using a home equity loan to pay off debt|
|Low interest rate||Risk losing your home|
|Low monthly payments||Difficult to discharge in bankruptcy|
|More time to repay the loan||Could extend the term of your current mortgage|
|Reduces number of accounts owed||If home value drops, you could pay more than it’s worth|
|You’ll know total cost of the loan upfront||Won’t solve the root cause of poor spending habits|
The Pros of Using Home Equity Loans to Pay Off Debt
If you’re dealing with high-interest debt from credit cards or personal loans, a home equity loan could help you pay off that debt at a lower interest rate than you have right now. This could save you a lot of money on interest, depending on what kind of rate you can get. And since a home equity loan allows you to consolidate multiple debts into a single loan, you’ll simplify your monthly payment schedule. This can reduce the stress of juggling multiple accounts and rates.
With terms of 5-30 years, home equity loans also give you more time to pay back your debt than if you were to use a debt consolidation loan or a personal loan. Although it takes a longer time to pay back than other types of loans, a home equity loan could take less time than if you were to just continue making minimum payments on your debt. And since the terms of your home equity loan won’t change over the life of the loan, you’ll know the total cost of the loan upfront.
The Cons of Using Home Equity Loans to Pay Off Debt
Even though a home equity loan could help you save money and pay off your debt faster than making minimum payments, there are risks involved in consolidating your debt with a home equity loan. Since you’re using your home as collateral on the loan, you may lose it if you miss payments. The debt associated with a home equity loan is also very difficult to discharge in bankruptcy. And if the value of your home were to suddenly drop, you’ll be stuck paying the original, higher value on the home you agreed to when you took out the loan.
Putting up your home as collateral might not be a wise choice if you’re dealing with a lot of debt because you made some bad spending decisions in the past. This doesn’t mean you can’t get out of debt, but you may want to look into lower-risk debt-relief options such as debt settlement or a debt consolidation loan (each discussed below).
When Should You Use a Home Equity Loan to Pay Off Debt?
Using a home equity loan to pay off debt could be a smart choice if you:
- Are dealing with high-interest debt from credit cards, personal loans, or other unsecured debt
- Own a home that is valued substantially higher than your current mortgage balance
- Are confident the value of your home will not decrease in the coming years
- Have a secure income
- Can afford your fixed monthly home equity loan payment
In 2019, the average interest for a 15-year fixed-rate home equity loan was 5.76%, which could be a lot lower than the interest rate you’re paying on credit cards or personal loans right now. So if you make enough income to afford your monthly home equity loan payments, you’re living in a home whose value is projected to increase in the coming years, and you’re looking for an affordable way to tackle your debt, a home equity loan could be the right choice for you.
However, if you don’t have much equity in your home, or if your financial situation is not stable right now, you probably shouldn’t take on the risk of a home equity loan. Likewise, if the home values in your neighborhood are decreasing, refinancing with a home equity loan could leave you with higher rates than you otherwise would have in the future.
Should You Use a HELOC or Cash-Out Refi Instead of a Home Equity Loan?
The term “home equity loan” is sometimes used interchangeably with a “HELOC loan” or a “cash-out refinance loan.” These are, however, three different types of refinancing mortgages available to homeowners. Which one is best for debt consolidation depends on what sort of debt you’re dealing with and how much equity you have in your home.
A traditional home equity loan is given to the borrower in a single lump sum. It is a fixed amount of money with fixed rates and terms, and your monthly payment will remain the same until you have paid it off.
A HELOC, or Home Equity Line of Credit, on the other hand, is a credit account that you can utilize over time—kind of like a credit card. With a HELOC, you aren’t required to use all of the equity available, so this can be a good option if you want to use your home’s equity over time to pay off some debt but don’t intend to use all of the equity.
A cash-out refinance allows you to refinance your mortgage and simultaneously borrow against the total value of your home and convert the equity to cash. You’re free to use the cash however you want, including as a way to pay off debt. You’ll have to pay the closing costs with a cash-out refi, but the interest rates are typically lower than a home equity loan.
If you don’t want to refinance your mortgage because the current mortgage rates are higher than what you’re paying now, you’re probably better off with a home equity loan.
What are the Risks of Using Home Equity Loans to Pay Off Debt?
The primary risk in using a home equity loan for debt consolidation is that a lender could foreclose on your home if you fail to make payments.
You might also end up increasing your total debt or your monthly minimum payments by taking on another loan. Plus, a home equity loan can take longer to pay off than a traditional mortgage. If you don’t feel comfortable with these risks, you might consider some alternatives to home equity loans.
Other Options for Consolidating Debt
In our survey, we asked over 1,000 American homeowners who have $10,000 or more in debt what type of financial products they’ve considered to help them pay off their debt. Here’s what they had to say:
While home equity products like a home equity loan, HELOC and home refinance top the list, there are other ways to deal with debt if you want to avoid home equity loans—including debt settlement, bankruptcy, and more. If you want to get out of debt without sacrificing your home equity, here are some options to consider:
Debt Consolidation Loan
Similar to a home equity loan, a debt consolidation loan is a lump sum that you use to pay off existing debt. If the average interest of your existing debt is greater than that associated with a debt consolidation loan, you could end up saving money and you don’t have to put your home up as collateral.
The root causes of debt for many individuals are bad spending habits. If you’re not sure how to make the right decisions with your credit in order to avoid serious debt, seeking out credit counseling could help you develop the necessary skills to manage your debt and tackle the problem at its source.
You may be able to settle your existing debt and pay less than what you currently owe. While some consumers work directly with their lender to lower their debt amount under new terms, many have worked with debt relief companies whose professional agents negotiate directly with lenders on their behalf in order to come to an agreement about debt repayment. The Certified Debt Consultants at Freedom Debt Relief have been helping people settle debt for over 15 years.
Often considered an option of last resort, bankruptcy could clear away a majority of your outstanding debt. But homeowners should be careful when considering this option. If you choose to file for Chapter 7 bankruptcy, your assets may be liquidated and you could lose your home. On the other hand, if you file for Chapter 13 bankruptcy, your home may be safe but you may face wage garnishment. Learn more about filing for bankruptcy.
Plenty of people struggle with debt, and it’s important to remember that you’re not alone. When it comes to dealing with debt, educating yourself is half the battle. Understanding that you have options, including using your home equity to pay off your debt, is a necessary first step if you’re looking to solve your debt issues. If you want to learn more about your debt relief options, check out our article on how to get out of credit card debt.