Wondering if using home equity to pay off debt is a good idea? The answer is, it depends. Home equity loans let you, the homeowner, borrow against the equity you built up on your property. Lenders tout it as easy access to cash, offering low rates and attractive terms.
If you have excellent credit and a stable monthly income, a home equity loan can be a good option. However, as with any secured loan, there are risks to consider.
How Does a Home Equity Loan Work?
A home equity loan allows you to tap into your home’s equity — the portion of the home you own, which is calculated by taking your home’s current value and subtracting it from your outstanding mortgage amount. Once you do close on a home equity loan, you’ll receive a lump sum of cash. Think of it as a personal loan, except you can typically borrow more money, and at lower rates.
Similar to a first mortgage, you receive a loan at a fixed rate. Each monthly payment is the same and will lower your loan balance until it reaches zero — within your predetermined term.
Simply having home equity doesn’t guarantee approval. Lenders typically have rigorous qualification requirements for home equity loans. This includes your credit score — most lenders require you to have at least 620 — proof of income and a debt to income ratio that’s less than 43%. This percentage represents your monthly gross income currently dedicated to paying off debt.
You’ll also be subject to requirements on your property. Lenders typically want you to have at least 15% to 25% equity in your home. To determine your home’s current value and, therefore, the amount of equity you have, lenders will ask that you go through the home appraisal process (which you’ll pay for).
Once approved, you can use the money towards anything you need — debt consolidation, credit cards, and medical bills.
How Is a Home Equity Loan Different From a Home Equity Line of Credit?
Also referred to by its abbreviation, HELOC, a home equity line of credit can seem like the better option if you don’t know how much you want to borrow, or if you want fast access to cash as you need it.
Instead of paying out a lump sum, you’re approved for a credit limit which you can take out during the draw period — which typically lasts a couple of years. You can keep borrowing as much as you need as long as you stay under the limit (which you can do by repaying a portion of your loan). That means you’ll only pay interest on the amount you actually borrow. This is a good option for those looking to make home improvements. Many home improvement projects are done over a period of time and you could pay less interest over the course of a 3 month project as you slowly purchase materials as needed. Alternatively if you were to take the lump sum of a home equity loan you would be paying interest on the entire amount of the project from the beginning.
Once the draw period is over, you’ll enter the repayment period — that’s when you start paying back your loan. The terms of how long you have to repay will vary depending on the lender.
Qualification requirements are typically the same as a home equity loan, except HELOCs tend to be variable rate loans. That means your rate can fluctuate throughout the lifetime of your loan.
What Are The Risks of Using a Home Equity Loan to Pay Off Debt?
Using a home equity loan to pay off credit cards or consolidate other types of debt can be a great idea, but there are some risks involved. Here’s what you need to keep in mind:
You’re Putting Your Home at Risk
It’s called a home equity loan for a reason — you’re using your home as collateral. That means if you default on the loan, you’re at risk of losing your property, unlike other types of loans where the consequences are late fees and damaged credit.
Proceed with caution unless you’re absolutely certain you can manage the monthly payments.
You Could Owe More Than Your Home is Worth
Home prices typically appreciate, but there are no guarantees – such as when the housing crisis happened back in 2008. While the housing market goes up and does go back down, the momentum is usually positive in the long term.
In 2008 with the property values dropping rapidly, unfortunately, many homeowners became upside down on their mortgages, owing more than the property was worth. When you are upside down on a loan, selling your home can be almost impossible.
It’s Expensive
Home equity loans aren’t cheap. While they can be less expensive than high-interest unsecured loans, you still need to pay to access your home equity. Many lenders charge origination fees and other closing costs, such as home appraisals or credit checks.
There are also high interest rates. If you have excellent credit, you may qualify for extremely competitive rates. However, the lower your credit score and the higher your DTI, the more likely it is that you’ll have to pay higher rates.
Variable-rate loans tend to increase over time, so your HELOC interest rate will most likely go up during the life of the loan. During the draw period you will be only responsible for paying the interest monthly. When your draw period is over and you enter the repayment phase then you will be paying principal and interest for the remainder of the term.
You May Not Get Access to Credit
Aside from the stringent credit requirements, HELOC lenders can cancel your loan, defeating the purpose of trying to borrow money in the first place. If the lender believes your financial situation has changed and you’re stretched too thin, or your home’s value drops significantly, then your HELOC can be taken away (permanently or temporarily).
What Can I Do If I Don’t Want A Home Equity Loan?
Most people think that the only way to tap into their home equity is to either take out a loan or sell their home and downsize. That’s not true. The real estate industry is continuously evolving, and programs like Point’s Home Equity Investment (HEI) are here to help.
Instead of charging you interest rates and high monthly payments, we invest in a portion of your home’s future appreciation.You can receive up to $350,000. Since we share in the loss if your home value drops, you’re not at risk of being upside down as you would be with a home equity loan.
In other words, you can free up your budget for what matters.
Some things that have helped credit scores rise is paying down revolving lines below 30 percent utilization, having the extra monthly funds to pay all payments to creditors on time, clearing up unresolved delinquencies are all things that are possible when using your home equity in a traditional mortgage or with and HEI like Point offers.
As with any significant financial decision, shop around to see the best option for your needs. If an HEI is right for you, pre-qualify today. It takes just a few minutes to get your offer.
Tags: Home Equity