If you’re struggling with credit card debt and own a home, you may already know that you can use your home to get out of debt. But you may not know how to do it, or what the possible risks could be. Let’s dive deeper into what’s involved in using home equity to pay off debt so you can determine whether it’s the right choice for your particular situation.
What Is Home Equity and How Can You Use it to Get out of Debt?
The difference between the value of your home and your current mortgage balance is known as your home equity. For instance, if your home is worth $250,000 and you have a mortgage balance of $100,000, you have $150,000 equity in your home.
Home equity is essentially the portion of your property that you actually own, as opposed to the amount you still owe to your mortgage lender. As you pay down the principal of your mortgage, your home equity grows. Your equity may also increase over time as the housing market changes. If your home’s market value goes up, you have more equity. If it goes down, you have less.
A home is the largest asset many people have, and when you have a lot of equity in your home, you have a lot of untapped capital. One way to tap into that capital is to sell your home. With enough equity, you could use the sale money to pay off your remaining mortgage balance and have money left over. The more home equity you have, the more money you’ll have left over to invest into another home, take a nice vacation, or pay off debt.
But selling your home is very disruptive and time-consuming. And while you may get money to pay off debt, you lose an incredibly valuable asset (your home). Luckily, if you’re struggling with high-interest credit card debt or have a financial emergency, there are several other ways to keep your home investment AND use your equity to get your finances back on track.
Here are some of the most popular ways to get out of credit card debt using the equity in your home.
Four Ways to Get Out of Debt Using Your Home Equity
1. Cash-Out Refinance
In a traditional refinance, you usually either refinance your current mortgage balance to get a lower rate and have a lower mortgage payment each month, or to pay off the mortgage faster. A cash-out refinance differs from a traditional refinance because the new mortgage you take out is for a larger amount than your current mortgage.
After the proceeds of the new loan are used to pay off your current mortgage and closing costs, you’ll receive the excess amount of cash in a lump sum. Let’s consider the example above where your home is worth $250,000, your mortgage balance is $100,000 and you have $150,000 equity in your home. If you’re in need of $30,000 in cash to help pay off your credit card debt, you can get a cash-out refinance for a total of $130,000 (the $100,000 you still owe on your home and the $30,000 you’d like in cash).
It is important to note that there are certain requirements you must meet before going this route. You may need to:
- Have owned your home for at least a year
- Hold a certain credit score
- Have a loan-to-value ratio (LTV) of approximately 85% of your home’s value (LTV = mortgage amount divided by your home’s appraised value)
If your goal is to pay off credit card debt, you may benefit more from a traditional cash-out refinance instead of a limited cash-out refinance. A limited cash-out refinance only allows you to take out either 2 percent of your new loan amount or $2,000 in cash (whichever is less) and use that money to pay your closing costs and other fees. But with a traditional cash-out refinance, you can take out up to 85% of your loan-to-value ratio and use the funds for anything you want, including pay off debt.
A traditional cash-out refinance can provide you with the large chunk of money you need to pay off credit card debt and improve your finances.
It may also help you reduce your taxable income and receive a larger refund check as mortgage interest payments are tax deductible. However, since a traditional cash-out refinance will require you to pay interest for 15 or 30 years, it’s only a good option if you’re able to secure a lower interest rate than what you’re paying on your current mortgage.
A home equity line of credit, or HELOC, functions like a credit card. You can borrow money up to a certain credit limit and pay it back with interest. A HELOC can allow you to withdraw or make payments as often as you’d like.
If you get approved for a HELOC, you’ll receive a maximum loan amount and be able to withdraw money as necessary during a set time period known as a draw period. In most cases, draw periods last for 5 to 10 years. When the draw period comes to an end, you’ll be in the repayment period, which typically lasts 20 years. Your HELOC will need to be paid off at the end of the repayment period.
A HELOC is a flexible option because it can allow you to borrow as much or as little money as you’d like to pay off your debts over a certain period of time. You’ll be able to pay interest that’s only compounded on the amount you draw rather than the total equity available to you.
While HELOCs do come with lower interest rates than other loan types, you’ll have to have a credit score of around 620 and at least 20% equity in your home. You’ll also be required to pay several upfront fees such as an application fee, title fee, and appraisal fee.
In addition, HELOCs feature variable interest rates that are based on an underlying benchmark interest rate and will fluctuate over time. If your income is unstable or you believe it may become lower at any point during your loan, it’s unlikely that a HELOC is a wise option as it may lead to foreclosure.
3. Home Equity Loan
With a home equity loan, you can borrow a lump sum of cash and use the value of your home as collateral. This type of loan acts as a second mortgage and comes with a fixed interest rate as well as a fixed repayment schedule, which is usually between 5 and 10 years.
Due to the fixed interest rate, a home equity loan is easier to budget for than a HELOC. It may save you from the shock that comes with rising interest rates that are out of your control.
However, a home equity is not as flexible as a HELOC because you receive one lump sum upfront and won’t have the chance to withdraw funds whenever you need. If you would like the flexibility of being able to borrow money at any time and do not want to deal with a large sum of cash at one time, a HELOC may be a better option.
The requirements to take out a home equity loan are similar to those of a HELOC and include a credit score of around 620 and at least 20% equity in your home. Keep in mind that the major disadvantage of a home equity loan is that tapping into all of your home’s equity at once can hurt you if the property values in your area decrease.
4. Shared Home Equity Agreement
Known by a variety of a names, a shared appreciation agreement, shared home equity agreement, or home ownership investment is a little-known alternative solution to taking out a loan. Shared home equity programs allow you to access your home’s equity in exchange for a portion of the property’s future appreciation without taking on additional debt. Here’s how:
- You apply for a shared home equity agreement through a company that offers a shared home equity program.
- You or the company you’re working with gets your home appraised to determine its value.
- The company gives you an investment offer based on the value of your home. This offer outlines how much they’ll pay you and how long you have to sell the home and pay them back, among other details.
- If you accept the offer, you get your money upfront. You do not have to make monthly payments or pay interest on the money you receive.
- When you sell the home, the company gets their money back plus an additional return based on whether the home has appreciated or depreciated in value.
This arrangement differs from that of a conventional loan or mortgage in that it uses a silent partner (or investor) who takes part ownership of your home. That means you do not incur any added debt, nor pay interest or monthly payments. Instead, the investor provides a lump sum/investment in exchange for the opportunity to share in the appreciation of the home’s value after it is sold. In the event the home depreciates— they share in that too – which may result in taking less of the home’s value when it is sold. There are certain restrictions and guidelines per provider to be aware of (these may include minimum/maximum time in home, upkeep of property, option to repay loan early, etc).
Although shared equity programs may seem like a new or unconventional way of leveraging the benefits of homeownership, the concept of equity sharing has actually been around in the US for over 30 years. Shared equity programs were once offered by affordable housing associates and municipalities to encourage homeownership to low-income or first time homebuyers. It is very similar to that of a family agreement, such as a parent co-investing in a home with a child.
Pros and Cons of Using Home Equity to Pay off Credit Cards
Debt consolidation:By consolidating your debt, you’ll receive one loan to pay off all your smaller loans. You’ll be left with one monthly payment that you’ll likely find to be easier to manage than several monthly payments. In addition, you may be able to pay off your debt faster because debt consolidation typically comes with lower interest rates than credit cards.
Savings on interest:Since home equity debt solutions come with fairly low interest rates (compared to credit card interest rates) and a set repayment period, they can help reduce the amount of money you spend on interest.
More time to pay it off:If you need some time to pay off your credit card debt, a home equity debt solution with a repayment period of 10 years may help you out. You won’t feel as much pressure as you may feel if you only have a few months or years to pay off your credit cards.
Home could be put at risk:Home equity debt solutions are backed by your home. If you’re unable to make your payments for any reason, you may lose your home and end up with nowhere to live.
Increased monthly payment:It may be difficult for you to keep up with higher monthly payments, especially if you’re currently facing financial challenges. Since a home equity debt solution will raise your monthly payment, it may not be a wise move for you.
It doesn’t always solve your debt problem:A home equity debt solution is not a magical way to get rid of your debt. If you are addicted to shopping or do not budget properly, your debt problem may continue. You should focus on being more mindful of your spending and creating a budget that helps you prioritize your spending, get out of debt, and achieve your long-term financial goals.
Should You Use Your Home Equity to Pay off Credit Card Debt?
Some financial advisors may argue that transferring your unsecured debt (like credit card debt) into secured debt (like your mortgage) may not be a wise choice. But the reality is, every person’s situation is different.
If you have average or good credit, can afford to make your monthly mortgage payments, and are confident that you’ll be able to make your home equity loan payments, using your home equity to pay off credit card debt could be a good idea.
However, if your debt is the result of poor budgeting and living above your means, this method will not resolve your debt. It’s also a poor option if you are having difficulty paying for everyday purchases and simply cannot make ends meet, or if you do not have a steady income.
Whether or not you choose to use your home equity, it’s crucial that you do something about your credit card debt. Credit card debt is one of the most expensive kinds of debt you can have, and it could take you years to pay it off if you’re only making the minimum payments.
If you’re interested in learning more about strategies you could use to get out of credit card debt, we encourage you to download our free How to Manage Debt Guide. It’s full of information about solutions that could help you solve your debt problem and start improving your finances.