Home Equity Loan For Debt Consolidation: Everything To Know

Do you wish you could combine all your debt payments into one to alleviate the giant headache of keeping track of all your bills? How about tapping into a home equity loan for debt consolidation? You can use a home equity loan to shrink your payments to one.

Let's look at other potential benefits, how a home equity loan works, how to qualify for one, the pros and cons and more.

What Is A Home Equity Loan?

First, what is home equity? Simply put, home equity is the difference between what you owe on your mortgage and what your home is currently worth. Equity can increase if the home’s value increases or through paying down the mortgage.  

A home equity loan, also called a second mortgage, is a type of home loan that allows you to borrow against the equity in your home. Your home serves as collateral to lower the risk to your lender.

How Does Paying Off Debt With Home Equity Work?

A home equity loan works like this: After approval, you receive a lump sum in cash from your lender, which you repay on top of your first mortgage. You'll typically repay your home equity loan over a 5-,10-, 20- or 30-year term in even payments with a fixed interest rate.

Note that homeowners cannot borrow 100% of their home equity – most lenders only let you withdraw between 80% – 90% of your home equity. Check with your lender to learn more about your limits.

You can calculate your equity by determining the amount left to pay on your mortgage principal. You can calculate it yourself by looking at the sales prices of the homes in your area and subtracting your loan balance from your home value.

You would then apply the sum you received from your home equity loan toward credit cards, personal loans, student loans or other types of debt.

Who Qualifies For A Home Equity Loan?

Let's take a look at the borrower requirements to take out a home equity loan:

• Amount of home equity: Homeowners generally must build up enough equity in their home to take out a home equity loan.
• Credit score: Your credit score refers to a three-digit number that shows how well you've historically handled debt. The minimum credit score requirement for a home equity loan will vary by lender.
• Debt-to-income ratio (DTI): Your debt-to-income (DTI) ratio compares your total monthly debt to your gross monthly income. The lower your ratio, the better because it indicates that you have less debt than your monthly income. You should aim for a DTI in the 43% to 50% range.
• Income and employment history: You'll need to prove that you're also in good financial shape. Your lender will also want to see verifiable income and employment history over the past 2 years.
• Reliable payment history: Lenders will want you to have made reliable, consistent mortgage payments on your first mortgage.

Pros Of Paying Off Debt With Home Equity

Let's look at the benefits of using a home equity loan to consolidate debt:

• Lower interest rate: Your home serves as the collateral for a home equity loan, which means you could potentially qualify for a lower interest rate than other types of loans, such as personal loans. Evaluate the difference between the interest rates of your current loans and your potential new interest rate.
• One monthly payment: Instead of making payments to several lenders separately – for student loans, personal loans, etc. – you will make one monthly payment to your lender.
• Potential tax deduction: You can use a home equity loan as a potential tax deduction if you use the money to improve your house or build a second one. Note that you may not qualify for a tax deduction on the interest paid if you don't use your home equity loan for those purposes. Check with your accountant for more information.

Cons Of Paying Off Debt With Home Equity

The disadvantages of using a home equity loan to consolidate debt include the following:

• Your house serves as collateral: One of the biggest downsides of a home equity loan is: Your home serves as collateral, meaning a lender can take your home from you if you fail to make adequate payments.
• Your debt burden increases: Tapping into your home equity through a home equity loan means you take on more debt. In addition to your first mortgage payment, you also make payments toward a second mortgage.
• Home value can decrease: Your home value can fall, meaning you might owe money on a home that has decreased in value, further lowering your home equity.

How To Use A Home Equity Loan To Pay Off Debt

How exactly do you use a home equity loan to pay off debt? Learn more in the steps below.

1. Find Out How Much Equity You’ve Built In Your Home

First, find out how much equity you've built in your home. Determine how much you owe on your home against the value of your home.

Let's say you owe $80,000, and you believe your home is worth $200,000. Subtract $80,000 from $200,000 to find your equity – in this case, it's $120,000.

2. Review Your Qualifying Factors

Double-check your qualifying factors – credit score, DTI, income and employment history and your past payment history. Your lender can help you figure out some of these qualifications, so check with them to ensure you're on the right track.

If necessary, you can boost your credit score by making on-time payments, disputing inaccurate credit reports and dealing with collections. You can also reduce your DTI by paying off debt or increasing your income.

Also, ensure you know how much you need to pay off your debts and how much you can repay monthly.

3. Compare Lenders And Interest Rates

Next, compare lenders and interest rates. Consider comparing interest rates with a few lenders to ensure you get the best rate possible. You may also want to evaluate the reputation of each lender and look up reviews online to ensure you're making the right lender decision.

4. Apply For The Home Equity Loan

You can apply for the home equity loan next, which you can typically complete on your lender's website. From there, your lender will ask you for some information such as bank account statements, pay stubs, tax returns and W-2s. Your lender will peek at your finances and check your credit score before approving you.

5. Get A Home Appraisal

The home appraisal process comes next. A home appraisal is a process in which a licensed appraiser evaluates your home to determine its fair market value. The appraiser uses recent sales of comparable homes and their expertise based on their walkthrough of the home to evaluate the home's market value.

6. Close On The Home Equity Loan

Once the home equity loan is approved, your lender will let you know. Be prepared to pay closing costs when you close on the loan. Closing costs encompass a few different fees, such as appraisal, credit report, documentation preparation, origination, notary, title search and other fees. You can expect to pay between 2% – 6% of your loan amount in closing costs.

7. Receive Your Lump-Sum Payment

Finally, you'll receive your lump-sum payment from your lender. Your lender then gets a second lien on your property. A lien is a legal claim against your property used as collateral to repay debt. Most home equity loan terms range from 5 – 30 years, and you'll repay your loan over that period.

8. Apply The Proceeds Toward Your Debt

Once you receive the lump-sum payment, apply it toward your outstanding debts. Whether you plan to pay off a student loan or a personal loan, contact the loan servicers handling each loan. They can help you learn more about the payoff process if you have questions.

Alternative Methods For Consolidating Debt

A home equity loan isn't the only method for consolidating your debt. You can also look into HELOCs, cash-out refinances, balance transfer credit cards or personal loans.

Home Equity Line Of Credit (HELOC)

A home equity line of credit (HELOC) is a type of second mortgage similar to a home equity loan. You borrow money against your home equity. However, a HELOC is a line of credit with two phases – a draw and repayment period.

During the draw period, you can use the line of credit however you need to make debt repayments. You'll repay principal and remaining interest once you reach the end of your draw period.

Unlike home equity loans with fixed interest rates, a HELOC often has a variable interest rate, which means it changes periodically.

Cash-Out Refinance

A cash-out refinance is a type of refinancing where homeowners can borrow money against their home equity – just like a home equity loan or HELOC. However, in a cash-out refinance, the homeowner takes out a new mortgage larger than the current mortgage balance. The new loan pays off the existing loan, and the difference between the two sums goes to you as cash.

Balance Transfer Credit Card

A balance transfer credit card is another way to pay off debt. A balance transfer card transfers your debt from one card to another, reducing your interest rate in the process.

Personal Loan

Personal loans, a type of installment credit, refer to funds borrowed from a lender that you repay in fixed monthly payments. They typically have higher interest rates than home equity loans because personal loans do not use collateral.

Home Equity Loan To Consolidate Debt FAQs

Still have lingering questions about home equity loans? Let's look at a few commonly asked questions.

Is a home equity loan good for debt consolidation?

A home equity loan for debt consolidation may or may not fit your needs. Whether it's a good fit depends on several factors, including the interest rate you will receive, the amount of home equity you currently have and your qualifications, like credit score and DTI. Ask yourself whether the home equity loan will cover your existing debt.

What happens if I don’t use all of my home equity loan to pay off debt?

If you don't use all your home equity loan to pay off debt, you can use it to achieve other goals, such as putting it toward a home renovation project or to pay for education costs.

Can I consolidate debt without tapping into my home equity?

Yes, you can consolidate debt without tapping into your home equity. There are several ways to do so. For example, you can consolidate federal student loans, meaning you combine several student loans into one loan with one monthly payment. You may also be able to get a debt consolidation loan, which does the same thing – it transforms your debt into one loan payment.

The Bottom Line

A home equity loan to consolidate debt can be a great way to achieve your goals. In addition to consolidating your loans into one monthly payment, you may lower your interest rate and qualify for a tax deduction. Evaluate the pros and cons of home equity loans and the alternatives to home equity loans before you make your move.

Interested in using your home equity to consolidate debt? Start a home equity loan application with Rocket Mortgage^® today.