Should You Use a Home Equity Loan to Pay Off Debt?
- A home equity loan to pay off debt can solve many financial problems.
- Debt consolidation with a home equity loan is the cheapest financing option for most consumers.
- Never consolidate debt without addressing spending habits. Or You'll end up worse off.
Debt can be stressful, and managing monthly payments may be a challenge if you’ve gotten in over your head. It may be tempting to just “wipe out your debt” by using a home equity loan to pay off debt. But taking out a home equity loan doesn’t really wipe out your debt; it just restructures it. And the “out of sight, out of mind” nature of home equity balances can temp you to rack up more debt once your balances are zeroed out. So, should you use a home equity loan or home equity line of credit to pay off debt?
In this article, we’ll explain how to use a home equity loan to pay off debt, 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.
Whether to Use a Home Equity Loan to Pay off Debt: Pros and Cons
Using a home equity loan or some other equity-based instrument to pay off debt may seem like a less appealing option than taking out an unsecured debt consolidation loan, but paying off debt with a home equity loan can be a smart choice in certain situations.
If you’ve owned your home for a while now, you may have built up equity in your home. The term equity describes 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 use it for other needs. There are many different ways to draw equity out of your home, including:
Home equity loan
Home equity line of credit (HELOC)
If you’re thinking of taking out a home equity loan to pay off debt, you’re not alone. But before you take action, you should consider the pros and cons.
The pros of using home equity to pay off debt
If you’re dealing with high-interest debt from credit cards or personal loans, using a home equity loan to pay off debt could help you pay a lower interest rate, 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 five to 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 higher-interest 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 to pay off debt
Even though using a home equity loan to pay off debt could help you save money and pay your debt faster than making minimum payments, there are risks involved. Since you’re using your home as collateral, 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.
When Should You Use Home Equity 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
As of this writing, the average interest for a 15-year fixed-rate home equity loan was 5.76 percent, which could be a lot lower (or higher) than the interest rate you’re paying on credit cards or personal loans right now.
However, if you don’t have much equity in your home, or if your financial situation is not stable, then you probably shouldn’t use home equity to pay off debt. 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 ways to use a home equity loan to pay off debt. 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 (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. When you use a home equity line of credit to pay off debt, you aren’t required to use all of the equity available, so this can be a good option if you pay off some debt but don’t intend to use all of it.
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.
The interest rates are typically lower than a home equity loan but the closing costs are much, much higher. It rarely makes sense to take a cash-out refinance to pay debt.
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, using a home equity loan to pay off debt can take longer than a traditional mortgage.
If you don’t feel comfortable with these risks, you might consider some alternatives to home equity loans, such as:
It’s important to understand that there is no one-size-fits-all solution to reducing or eliminating debt. Whether you use home equity to pay off debt or one of the other available methods will depend on your unique situation, your credit rating, your income, and your financial goals.