7 Steps to Consolidate Debt with a Home Equity Loan

Anybody who’s carrying a significant amount of debt knows that it can sometimes be overwhelming to think about the best way to pay it down. Outstanding debt can impact your ability to make major purchases such as a house or car. If you want to consolidate debt, there are multiple ways to do it.

At Addition Financial, we help our members pay down existing debt all the time and one question that we hear a lot is this.

“Can I consolidate debt with home equity?”

The short answer is yes, and in this post, we’ll explain when it’s a good idea and give you the seven steps needed to consolidate your debt by borrowing against your home equity.

When should you consider debt consolidation?

Debt consolidation isn’t the right choice for everybody. Here are some signs that might indicate that consolidating your debt could be helpful.

You have several monthly debt payments.

For some people, making monthly payments toward multiple debts can be stressful and even overwhelming. If that sounds familiar, then you may find it easier to take out a debt consolidation loan, leaving you with just one monthly payment to make.

Your debt comes with high interest rates.

It’s common for certain types of debt, especially credit card debt, to come with high interest rates that add to the time it takes to pay off the debt and impact your wallet, too. We suggest reviewing your interest rates and, if they’re high, taking out a home equity loan could help you qualify for a lower interest rate and decrease your total monthly payment.

You have a budget and plan to stay out of debt going forward.

Debt consolidation only makes sense if you use the opportunity to pay down your existing debt and have a plan to avoid getting into debt again. We’re not suggesting that all debt is bad or that you should aim for zero debt, but many people who consolidate debt do so because they’re in over their heads, and having a plan can prevent debt from turning into a cycle.

Your credit score has improved.

A lot of consumers apply for credit cards or take out loans at a point in their lives when their credit scores are lower than they’d like. If your credit score has approved substantially, then you are likely to qualify for a more advantageous interest rate than what you have and debt consolidation could be useful.

Should you use a home equity loan to consolidate debt?

There are both benefits and risks to taking out a home equity loan or second mortgage to consolidate your debt. Let’s start with the benefits:

  • Lower interest rates. In many cases, a home equity loan may come with a lower interest rate than a credit card or even a personal loan. Even a small reduction in your interest rate can save you thousands of dollars as you repay your debt.
  • Smaller monthly payment. As we mentioned above, consolidating your debt may mean that your total monthly debt payments are reduced based on a lower interest rate.
  • Quicker debt payoff. Consolidating your debts can mean that you’ll be able to get yourself out of debt more quickly than you would without consolidation.
  • Predictable payments. As long as your home equity loan comes with a fixed interest rate, you’ll have the benefit of knowing your exact payment each month and a fixed timeline for when you will be out of debt.

Here are some potential disadvantages of using a home equity loan to consolidate your debt:

  • Your home is collateral. When you borrow against your home equity, you’re using your ownership stake in your home as collateral. If you fail to make payments on your home equity loan, you run the risk of losing your house.
  • Borrowing is limited. Because a home equity loan uses your equity as collateral, you are likely to be limited in how much you can borrow. Many lenders won’t allow debt of more than 80% of the home’s value on any mortgage.
  • Fees may be high. You’ll have to pay closing costs on your loan and these costs will eat into the amount you have available to pay down your debt.
  • Your interest won’t be tax deductible. The interest on a home equity loan is typically tax deductible only if you use the funds from the loan to make improvements to your house.

You’ll need to weigh the pros and cons of using a home equity loan to consolidate your debt before you move forward.

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7 steps to use a home equity loan for debt consolidation

Now that you understand the basics of home equity loans and why you might want to consider using one to consolidate your debt, here are seven steps to apply for a home equity loan and consolidate your debt.

#1: Crunch the numbers.

The first step is to crunch the numbers to determine two important facts:

  • How much equity you have
  • How much cash you need

If you don’t have enough equity to consolidate all of your debt, our suggestion would be to start with the balances with the highest interest rates because you’ll save the most money by consolidating those.

#2: Gather necessary documents.

The next step to applying for a home equity loan is to gather the necessary documentation to apply. Most lenders will require the following items:

  • Pay stubs for the most recent 30-day period
  • W-2s for the most recent two years
  • Asset statements
  • Proof of homeowner’s insurance
  • Tax returns for the most recent two years (applies if you are self-employed or receive income from rentals, bonuses or tips)

Collecting your documentation ahead of time will streamline the process of applying for a home equity loan.

#3: Choose your lender.

The second step is to choose a lender. You should research lenders ahead of time and make notes about loan terms and other specifics. Narrow your list down to a minimum of three lenders and get quotes from all of them to compare costs and other features.

There may be an advantage to getting your home equity loan from the same lender who provided your mortgage. For example, Addition Financial mortgage holders can get up to 90% financing, while those with mortgages from other lenders may receive a maximum of 80% financing.

#4: Complete your loan application.

After you have selected potential lenders, it’s time to complete your loan application. Be sure to fill in all fields completely.

It’s at this stage that you’ll be asked to supply the supporting documentation we mentioned earlier, so be sure to collect everything and submit a complete package. Doing so will minimize the risk of delays in the underwriting process.

#5: Respond to questions quickly.

The loan underwriting process may take time and, as it occurs, it’s possible that your lender will have questions for you or require additional information to complete your underwriting.

Replying quickly will minimize the risk of any delays in underwriting and will help you get to your loan closing as quickly as possible.

#6: Close on your home equity loan.

If your loan is approved, you’ll attend a closing where you’ll sign the necessary loan documents and complete the steps to receive your funds.

The closing may take place several weeks after your loan is approved but may happen more quickly. You will need to provide instructions for how you want to receive the money; most people prefer an electronic transfer.

#7: Use the funds to pay your debt.

The final step in the process is to use the funds from your home equity loan to pay your debt. Depending on how many credit cards and other debts you have, you may need to perform several transactions.

As we mentioned above, if you don’t have enough money to pay all of your debts, you will need to strategize about how to use the funds you receive. There are two main options available to you:

  • Avalanche. Pay the debts with the highest interest rates first, leaving only the amounts with the lowest interest rates to repay separately.
  • Snowball. Pay the highest balances first, leaving only the smallest total balances to repay separately.

If your goal is to save money in the long term and you have a home equity loan with a low interest rate, then you should choose the Avalanche method.

If you are carrying debt, especially high-interest debt, then it may be helpful to use your home equity to borrow the money you need to pay off your debts. With a low interest rate, debt consolidation can potentially save you thousands of dollars.

Are you thinking about leveraging your home equity to pay off your debts? Addition Financial Credit Union is here to help! Click here to read about our home equity loans and start the application process today.

The content provided here is not legal, tax, accounting, financial or investment advice. Please consult with legal, tax, accounting, financial or investment professionals based on your specific needs or questions you may have. We do not make any guarantees as to accuracy or completeness of this information, do not support any third-party companies, products, or services described here, and take no liability or legal obligations for your use of this information.