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?
The difference between the value of your home and your current mortgage balance is 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 your lender. As you pay down the principal of your mortgage, your home equity grows. Your equity may also change 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.
When you have a lot of equity in your home (typically your largest asset), you have a lot of untapped capital. One way to tap into that capital is to sell your home. With enough equity, you could pay off your remaining mortgage balance and have money left over. 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 debt or a financial emergency, using home equity to pay off debt—while keeping your home—is an attractive option.
Four ways of using home equity to pay off debt
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 remaining $30,000 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 1 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 percent of your loan-to-value ratio and use the funds for anything you want.
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 currently paying.
A home equity line of credit (HELOC) functions like a credit card, allowing you to borrow money up to a certain credit limit and pay it back with interest, and 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.
Using home equity to pay off debt through a HELOC is a flexible option because you may borrow as much or as little money as you need 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, requirements include:
- A credit score of around 620
- At least 20% equity in your home
- Upfront payment of an application fee, title fee, and appraisal fee
In addition, HELOCs feature variable interest rates that are based on an underlying benchmark interest rate that fluctuates 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 and a fixed repayment schedule, usually between five and 10 years. However, a home equity loan isn’t as flexible as a HELOC, because you receive one lump sum up front and won’t have the chance to withdraw funds whenever you need.
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 percent 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 names, the shared appreciation agreement, shared home equity agreement, or home ownership investment is a little-known alternative solution to taking out a loan. These 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 such programs
- You have your home appraised
- The company makes an investment offer based on the value of your home, outlining 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 without having to make monthly payments or pay interest
- 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 other ways of using equity to pay off debt as it uses a silent partner (or investor) who takes part ownership of your home. The investor provides a lump sum in exchange for the opportunity to share in the appreciation of the home’s value after it is sold. If the home depreciates, they share in that too and would end up taking less of the home’s value when it is sold. There are certain restrictions and guidelines per provider to be aware of, such as minimum or maximum time in home and upkeep of property.
Pros and cons of using home equity to pay off debt
- 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 and may be able to pay off your debt faster because debt consolidation typically comes with lower interest rates than credit cards or other unsecured debts.
- Savings on interest: Since home equity debt solutions come with fairly low 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 debt, a home equity debt solution with a repayment period of 10 years may help you out.
- 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.
- Increased monthly payment: Since a home equity debt solution will raise your monthly payment, it may be difficult for you to keep up with these higher payments, especially if you’re currently facing financial challenges.
- 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 don’t budget properly or prioritize your spending, your debt problem may continue.
Should you use your home equity to pay off 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 everyone’s situation is different. If you have average or good credit and are confident that you’ll be able to make your monthly payments, using equity to pay off 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 can’t make ends meet. Regardless of whether you choose to use your home equity, it’s crucial that you do something about your credit card and other unsecured debts.
Take charge of your financial future today
If you are struggling with your finances, using home equity to pay off debt is one of many options. Freedom Debt Relief is here to help you understand your debt relief options, including our debt settlement program. Our Certified Debt Consultants can help you find a solution that will put you on the path to a better financial future. Find out if you qualify today.