Pros and Cons of Using a Home Equity Loan or Line of Credit to Pay Off Debt[yoast-breadcrumb]
Pros and Cons of Using a Home Equity Loan or Line of Credit to Pay Off Debt
Paying off debt can be a huge challenge, especially if you have high-interest credit cards or other loans. One option some homeowners consider is leveraging their home equity to consolidate debt into a new loan with a lower interest rate. This can be done through a home equity loan or home equity line of credit (HELOC). While this approach has some benefits, their are also risks to be aware of. This article will break down the key pros and cons so you can determine if its the right debt payoff strategy for your situation.
What is a Home Equity Loan or Line of Credit?
A home equity loan lets you borrow a lump sum of cash, up to a percentage of your home’s value, that you pay back with fixed monthly payments over a set repayment term. Rates are usually lower than credit cards or personal loans.
A HELOC also lets you access your equity, but instead of a lump sum you get a revolving credit line. You can draw from the line as needed, then make monthly payments on the balance. HELOC rates are variable but usually start lower than other debt options.
Pros of Using Home Equity to Pay Off Debt
Lower Interest Rates
This is the biggest benefit. Home equity loans and HELOCs typically have much lower interest rates compared to credit cards or personal loans. The current average rates are:
- Credit cards – 18%
- Personal loans – 10%
- Home equity loans – 7%
- HELOCs – 6%
Consolidating high-rate debts into a home equity product can reduce the total interest you pay over time, helping you pay off the debt faster. This chart shows potential savings over 5 years if you consolidated $20,000 of credit card debt at 18% into a home equity loan at 7%:
|Debt Type||Interest Paid|
|Home Equity Loan||$4,800|
Thats a potential savings of $3,400 just by getting a lower interest rate!
Pay Off Debt Faster
Because home equity loans have fixed monthly payments, it creates a plan to pay off your debt in a set timeframe, usually 5-30 years. This payoff schedule can motivate you and prevent the debt from lingering.
With HELOCs you’ll need self-discipline to pay more than the minimum each month. But the lower interest rate makes it easier to pay extra and pay off the balance faster.
Consolidate Multiple Debts
Rolling multiple debts into a home equity loan or HELOC can simplify your finances. You make one monthly payment instead of keeping track of several. Taking out a HELOC is often free as well.
Access Cash Quickly
Home equity loans fund in a lump sum you can use right away to pay off debts. HELOCs give you access to a revolving credit line to draw from as needed. This can be useful for managing unexpected expenses.
Potential Tax Benefits
The interest paid on home equity debt is usually tax deductible if you itemize deductions. This can provide some extra savings each year. Always consult a tax professional to understand how this could benefit you.
Cons of Using Home Equity to Pay Off Debt
Risk Losing Your Home
This is the biggest risk to understand. Home equity loans and HELOCs use your home as collateral. That means if you default on the loan your lender can foreclose and force a sale of your home to repay the debt. Be 100% sure you can afford the payments before borrowing.
Interest Rates Can Change
Home equity loans have fixed rates that won’t change. But HELOC rates are variable and tied to the Prime Rate, so if rates rise your payment would increase. Make sure your budget can handle potential rate hikes over the loan term.
Closing Costs and Fees
You’ll pay closing costs of 2% to 5% of the loan amount to take out a home equity loan. HELOCs have lower or no closing costs. Factor these fees into your total costs, as they can add up on a larger loan.
The Debt Remains
While consolidating debt can simplify payments, your total debt hasn’t changed. You still owe the same amount, just through a different product. Make a plan to pay more than the minimums so you can become debt free.
You Use Up Home Equity
Tapping equity reduces the amount of ownership stake you have in your home. This leaves you less equity to borrow against in the future if needed for other reasons. Only borrow what you need.
Discipline is Required
Having access to borrowed cash can lead some borrowers back into bad habits. Use your home equity loan or HELOC responsibly to pay off debts and don’t accumulate new debt.
Alternatives to Consider
Using home equity to consolidate debt has clear benefits, but also risks. Before choosing this option, also consider:
- Balance transfer credit cards with 0% intro APR
- Debt management plans through credit counseling agencies
- Debt consolidation loans
- Paying more than the minimums on current debts
Explore all your options to find the right debt payoff strategy for your situation. And make sure you address the root causes of your debt so you don’t end up in the same situation down the road. The key is developing healthy spending habits and living within your means.
In summary, tapping home equity can provide an affordable way to consolidate and pay off debt faster with lower interest rates. But make sure you go in with your eyes open to the risks and commit to using the funds responsibly. With the right planning, a home equity loan or HELOC can be a valuable part of your debt freedom journey.