Every year, millions of Americans find themselves in debt, and many more find themselves trying to determine the best approach to getting rid of that debt, or at least make it more affordable. There are a host of ways to do that, including taking out personal loans or transferring debt from one credit card to another. Thanks to low interest rates, however, many homeowners today also are tapping into home equity to ease their debt burdens.
Establishing and leveraging home equity
Home equity is the difference between the market value of your home (e.g., what a buyer would pay) and your existing mortgage balance. For example, if your house is worth $250,000 and your outstanding mortgage is $200,000, your equity would equal $50,000.
Traditionally, this equity builds over time, with each mortgage payment decreasing the amount owed and increasing the available equity. For many Americans, home equity represents one of their largest financial assets. A home equity loan, a home equity line of credit (HELOC) or a combination of the two, offers consumers a way to tap into that asset via a temporary (typically five to 15 years) lending agreement, negating the need to sell property to access the cash.
If you currently have debt and you’re considering tapping into your home equity in order to lighten the burden, here are a few things to consider.
1. Consumer debt is steadily increasing
In other words, you’re not alone. In the first quarter of 2018, 174.9 million consumers had access to a credit card, and on average, consumer debt per borrower was hovering around $5,472, with both numbers steadily increasing over the last few years.
Of course, credit card debt isn’t the only type of debt weighing down homeowners. Vehicle loans, educational expenses, medical bills, legal fees, and home repairs can all quickly add to the seemingly never-ending financial obligations.
2. Home equity can be used to consolidate various types of debt
When it comes to debt, one of the biggest challenges can be managing multiple accounts and their respective balances and due dates. Missed payments and subsequent fees can quickly add up, and in some cases even cause interest rates to rise, feeding the cycle.
A home equity loan, HELOC or a combination of both can be used to consolidate credit card, auto and other debt into one payment, making it easier to manage and work toward debt freedom.
3. The difference between home equity loans and lines of credit
Home equity loans, HELOCs or a combination of the two can be viable means to pay down debt, finish home improvements, or even fund a new business venture, and while the idea behind both is similar (lending based on the equity of your home), there are significant differences.
A home equity loan is a lump sum that the borrower receives upon closing. The borrower will take ownership of the full sum, and fixed payments will be made in accordance with the loan agreement.
A home equity line of credit, or a HELOC, is revolving debt, typically with a variable interest rate. As such, the borrower is approved for a specific sum, but they are under no obligation to use the full sum, drawing on it only as needed for the duration of the draw period. Repayment is based on the amount used and can fluctuate based on the current prime interest rate or LIBOR. There are also hybrid loans that incorporate both a lump sum and line of credit.
4. Home equity loans and lines of credit typically carry a lower interest rate than credit cards, making them more affordable
Generally speaking, the average credit card APR hovers around 16 percent, though those with poor credit may be carrying debt with an APR over 23 percent. (Though similar, there’s a difference between APRs and interest rates. APRs incorporate fees along with interest rates.) On the other hand, depending on your credit standing, the APR and interest rates on home equity loans and HELOCs can be considerably lower – even 10 points lower for qualifying borrowers. In fact, the current average home equity loan rate is well under 6 percent. The difference in the cost of these loans can be considerable, particularly when paying down debt.
Often, people consolidate credit card debt by transferring balances to a new credit card. That new card may have a comparably low or even zero percent APR for an introductory period. That said, there are balance transfer fees to consider, and if you ever miss a payment or are late, the APR could spike to a high rate – perhaps even retroactively.
5. Home equity loan limits depend on your existing equity
In most cases, lenders will only extend a home equity loan or line of credit when you own at least 20 percent of your home (i.e., have 20 percent equity). Further, the total amount you are eligible for hinges on a variety of factors, including credit scores and current income, but often lenders will not approve loans or lines of credit for more than 85 percent of the total equity value.
6. A home equity loan carries a definitive limit and term, making it easier to budget
Depending on the type of debt you have, it’s not uncommon to see your monthly bills continue to grow despite making regular payments. When interest rates are high and minimum payments are low, it can be incredibly difficult to put a dent in your debt.
A home equity loan is for a single lump sum, and upon closing, the borrower agrees to pay a specific amount for the term of the loan. That lump sum can then be used to pay off existing debt. For many homeowners, this makes it easier to steadily pay down debt and budget appropriately for the duration of the loan term.
7. Home equity loans and lines of credit are secured debt, while personal loans and credit cards are usually unsecured debt.
This is an important distinction that often is a factor when determining what type of loan you wish to secure. Home equity loans and lines of credit are secured, which means they are backed by an asset. Should you default on the loan, the lender may have the right to claim that asset, and take it from you. This is in contrast to unsecured debt, which does not leverage any of your current assets as collateral.
Is there a benefit to secured debt versus unsecured debt? The short answer is yes. Since secured debt is backed by an asset, the interest rates are typically lower when compared to unsecured debt. This also typically makes secured loans more affordable.
However, since the home is the primary asset in a home equity loan, those who choose to move forward with this type of loan must do so with confidence that they will be able to make payments on-time for the duration of the term.
8. Regularly paying your home equity loan or line of credit can help improve your credit score
Once your debt is under control and high interest loans or outstanding credit card debt are consolidated, making regular, timely payments on your home equity loan or line of credit can have a positive impact on your credit score over time, assuming no additional debt or missed payments come into play.
9. The way you use the funds from a home equity loan will dictate tax deduction eligibility
As of the 2018 tax year, tax payers can only deduct interest from home equity loans if they use those funds for home improvements, and even then a number of factors come into play. As such, it’s important to keep in mind that interest paid on home equity loans and lines of credit used for debt consolidation will not be deductible come tax time. It’s important that you speak with a financial advisor or tax professional about whether you qualify for a deduction.
10. Home equity loans and lines of credit can help you pay down debt faster.
If you’re paying down high-interest debt (e.g., credit cards with 16-23 percent interest rates), and you’re only paying the minimum due, it’s possible that only a small fraction of your payment is actually chipping away at the principal, meaning you’ll spend more time (and money) paying off debt. A home equity loan and/or line of credit with a lower interest rate can meaningfully cut down on both the time and money you spend paying back your debt.
Being trapped in a cycle of expensive debt can be incredibly stressful. In fact, a 2013 study from The National Institute of Mental Health found that “debt is an important socioeconomic determinant of health.” For some, tapping into home equity may just be the key to breaking that cycle by cutting both interest rates and the time it takes to pay off the debt, thereby easing the burden and helping you reach your financial goals that much faster.