How to Use Your Home Equity to Pay Off Debt

Becoming debt-free is one of the many significant steps towards a secure future. Repairing credit is also something many American’s are currently working on. While time is the main factor towards improving your credit there are ways to help speed the process along. If you are currently worried about your credit you are not alone and there are things that can be done to help. 

Assuming you have enough equity in your home, this type of debt consolidation can be an inexpensive option compared to other high-interest debt choices. 

How does using home equity to pay off debt work? You borrow against the equity you’ve built up on your home — its current value minus what you still owe on your mortgage. In many cases, you’ll receive a lower interest rate compared to personal loans, payday loans, or debt consolidation programs. Then you can use your home equity loan for debt consolidation purposes such as paying off credit cards, medical or tax bills. 

What Are Your Options For Using Home Equity to Pay Off Debt?

The good news is that there are a few ways to tap into your home equity, each with its benefits and drawbacks. Typically, you’ll be able to use a home equity loan to pay off credit cards, existing loans, or for other purposes. Though all of the below types will have a similar application process, the loan terms can be different. As with all major financial decisions, taking the time to make an educated decision will go a long way.

Home Equity Loan

A home equity loan is typically a fixed-rate loan that uses your property as collateral for the debt. It’s sometimes referred to as a secured loan. This could be a refinance of your first mortgage or this could be a second mortgage on the property with a secondary monthly payment. How it works is that once you’re approved, you’ll receive a lump-sum payment based on the amount of equity you have in your home — usually a minimum of 15% to 20%. If your home is worth $250,000, you’ll need at least $37,500 to $50,000 in available equity. 

To qualify, you need a credit score above 620. You’ll also need a debt-to-income ratio of 43% or less. This number is expressed as a percentage that compares your income to the amount of debt you’re currently paying down. Lenders want to see this number to see how feasible it is for you to take on another loan. 

To calculate your debt to income ratio, divide your monthly debt payments by your gross income (before taxes). For example, if your debt payments are $1,600, and your gross monthly income is $2,500, your debt to income ratio is 64%. 

Terms and rates will depend on factors such as your income, credit score, and how much debt you currently have. In many cases, home equity loans will offer terms from 5 to 30 years. The lower your credit score and higher your amount of debt, the less likely you’ll qualify for the lowest rates, if at all. Once you receive your loan disbursement, you’ll need to pay it back through fixed monthly payments.

Home Equity Line of Credit (HELOC)

Also referred to as a HELOC, this type of home equity loan is revolving debt, much like a credit card. Once approved, you’ll receive a loan limit that you can draw from. For example, if you have a $50,000 limit, it means you can borrow up to that amount.

There are two distinct periods for a HELOC: the draw period and repayment period. The draw period is where you can get funds up to the amount of the credit limit as often as needed. If you pay down the loan balance during this time, you can borrow it again until the draw period is over. During the repayment period, you start paying back the outstanding balance, plus any applicable interest.

There are HELOCs with fixed rates, but many will also offer variable rate loans, meaning the interest rate can fluctuate. That means your monthly payments can differ depending on the amount you borrow and current market rates. Qualifying for a HELOC is similar to qualifying for a home equity loan, though individual requirements will differ from lender to lender.

Depending on the lender, you might be subject to an annual fee for the privilege of having a HELOC and be required to maintain a certain balance. Also, you may be required to take out a certain amount upfront plus minimal withdrawal amounts afterward. 

Cash-Out Refinance

A cash-out refinance is where you take out a new loan to replace your existing mortgage. The new loan amount will be higher than what you currently owe — you’ll receive the difference in cash.

For example, let’s say your home is currently worth $300,000, and you still owe $150,000 on the home. You want to borrow $25,000 to consolidate a few high-interest personal loans. You then refinance your home for a $175,000 mortgage and take the $25,000 difference to use towards debt consolidation. Now you have a new mortgage, and your high-interest debts are paid off, leaving you with one monthly payment moving forward.

Ideally, your cash-out refinance offers a lower interest, saving you even more money in the long run. To qualify, you’ll typically need a debt to income ratio of less than 50%, a minimum 620 credit score, at least 15% equity in your home, and a history of on-time payments.

Downsides to Using Home Equity to Pay Off Debt

The main benefits of using home equity loans to pay off debt are a) the chance to get a debt consolidation loan at a lower interest rate and b) simplified monthly payments. Homeowners who choose a fixed-rate loan will have the luxury of knowing how much time it’ll take to pay off the entire balance of their loan.

However, home equity loans come with a few significant drawbacks. While using home equity to pay off debt can be beneficial for many people, it’s not financially feasible for everyone. 

You Need Good Credit 

Most home loan programs require homeowners to have a minimum credit score (typically 620) and other financial requirements such as a history of on-time payments and a debt to income ratio of 50% or less. In other words, you cannot have more than a certain amount of debt, or you’ll need to meet certain income thresholds. 

Even if you qualify for a home equity loan with a lower credit score, you may not get the lowest rates — you could pay more throughout the lifetime of the loan. The lower the credit score, the more risk for lenders. To mitigate this risk the lender will normally tier the interest rates based upon credit scores, income, and condition of the property.  For example, you have a 600 credit score and a debt to income ratio of 25%. 

You Could Lose Your Home

There’s a reason home equity loans are called secured loans — your home acts as collateral. If you default on your obligations to a home equity lender, they could foreclose on the property. The events of default could vary depending on the lender, but if you aren’t making your monthly payments that’s guaranteed to be an event of default. Other types of events of default include letting your property insurance lapse, not paying your property taxes, and more.

You Might Not End the Debt Cycle

Even though you are paying lower interest rates, you’re still in debt. That means if you’re already struggling to pay back what you owe, you might run the risk of falling more into debt. Even with the best of intentions, debt consolidation may not be the answer, especially if you barely have any breathing room in your budget as is. 

You Need to Pay Closing Fees

Most home equity loans require homeowners to pay closing fees, like what you paid when you took out our mortgage. Some of these fees could include the cost of getting a credit check, home appraisal, and annual fees for HELOCs. 

What Are The Alternatives?

The good news is that there are alternatives to home equity loans that don’t involve taking out another personal loan or opening another credit card – for example, Point’s Home Equity Investment (HEI). Point invests in a portion of your home’s future appreciation. Depending on the amount of home equity you have and your home value, you can get up to $350,000.

Since this is an investment, you’re not subject to monthly payments. Instead, when you sell your home (or once 30 years is up), Point will take a portion of the shared appreciation. You can also pay Point back any time within the 30-year term — there are no penalties or lockout. 

It takes a few minutes to see if you qualify (and you’re not committed to anything at this time), so get your pre-offer and see if Point is the right fit for your needs.

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