Using home equity to consolidate your debt
Home equity and managing debt
- A home equity loan, home equity line of credit and cash-out refinance can be used to consolidate debt.
- Debt backed by home equity typically has lower interest rates than credit cards or other unsecured consumer loans.
- The amount you owe on your home, credit score and debt-to-income ratio determine your eligibility to tap into home equity.
Debt consolidation is a way for a borrower to combine multiple loans into one new loan to achieve a lower interest rate and monthly payment and to simplify debt management. Using home equity is a common method of debt consolidation because of the favorable interest rates.
Accessing home equity can be accomplished via a home equity loan, a home equity line of credit or a cash-out refinance. Because home equity debt is secured by property, they normally carry lower interest rates than a borrower’s existing unsecured debt, such as personal loans or credit cards.
Home equity loans are a popular method of debt consolidation, given that a borrower can calculate their total debt owed and take out a loan accordingly. As a lump-sum term loan, most have fixed rates and fixed monthly payments for a typical term of five to 15 years. Interest is normally tax-deductible.
A home equity line of credit is a revolving credit facility that usually carries a variable interest rate. They are less frequently used for debt consolidation, as credit lines are designed for intermittent cash withdrawals over time. Interest is only paid on the amount of money drawn and can be paid off and drawn out again.
With cash-out refinancing, the borrower extracts the equity in their house in cash as part of a larger refinancing of the mortgage. The cash can be used to pay off existing debts. This can be a prudent option if the refinancing does not raise the mortgage interest rate or monthly payments.
Eligibility and process
To reap the benefits of using home equity to consolidate debt, you must have sufficient equity in your home, a strong credit score and a low debt-to-income ratio. Lenders typically require a minimum credit score of 620 for a home equity loan, 660 for a home equity line of credit and 640 for a cash-out refinance — although those benchmarks can vary by lender. To gauge whether tapping your home equity to consolidate debts makes sense for you, take the following steps:
- Calculate your total debt, average interest rate and the total time to pay it off.
- Identify how much equity you have in your home — the difference between your home’s value and the outstanding principal on your mortgage — and whether it is enough to cover your combined debts. Lenders will typically require that the loan-to-value ratio — the total debt on your home divided by its market value — does not exceed 80 percent, after accounting for the home equity loan, line or cash-out.
- Compare the interest expense on the home equity financing to see if it is better than the rates and terms of your existing loans.
- Apply for the best home equity option — loan, line of credit or cash-out refi — given your situation. Approval can take up to 10 days and funds disbursement occurs up to 30 days thereafter.
Factors to consider
Because saving money is the primary objective of debt consolidation, interest rates are a key factor to consider when tapping your home equity. If you currently hold high-interest loans, such as credit card or auto loan debt, using home equity to consolidate that debt will almost certainly result in a lower rate.
Make sure the interest paid on the home equity loan, line or cash-out refi over the entire term of the financing is less than it would be with the existing debt it is replacing. If the repayment period for the new debt backed by your home’s equity is longer than it is for the existing loans, or you carry a balance on a home equity line of credit, your overall interest expenditure may rise.
Most loans backed by home equity have similar fee structures to mortgages, including application, origination and annual fees. Some online lenders waive these fees, so it is worth shopping around.
The most significant concern when using home equity to consolidate debts is that you risk losing your house if you default on the restructured debt. Consequently, it always pays to use home equity wisely.