Owning a home comes with some significant benefits, including the freedom to do whatever you want with your property and the ability to borrow against your equity in your home. While it’s common to use home equity loans for renovations or home improvements, the truth is that you can use a home equity loan for any expenses you choose.
Our Addition Financial members sometimes come to us for advice about debt consolidation loans. One option that some are surprised to learn about is taking out a home equity loan for debt consolidation. While it’s not the right choice for everybody, people who have sufficient equity may find it beneficial to use it to borrow the funds necessary to consolidate their debt. Here’s what you need to know.
What is a home equity loan for debt consolidation?
A home equity loan is a loan that uses your equity in your home — the amount you own free and clear — to consolidate debt, usually at a lower interest rate than the existing debt. Home equity may be acquired by making a down payment when you buy a home as well as by making monthly mortgage payments.
To get a home equity loan, you will typically need more than 20% equity in your house. So, if your house is appraised at $400,000 and you owe $300,000 on it, you would have 25% equity and have about 5% of your home’s value — in this case, $20,000 — to borrow against.
A home equity loan uses your home’s equity as collateral, so it’s important to be sure you can afford the monthly payments before taking out a home equity loan. If you miss payments, then you would run the risk of losing your home in a foreclosure.
What types of debt can be consolidated with a home equity loan?
Anybody who is carrying a significant amount of high-interest debt may be wondering which types of debt can be consolidated with a home equity loan.
Credit card debt
The first type of debt that can be consolidated using a home equity loan is credit card debt, which tends to have high interest rates when compared to many bank loans. Debt consolidation can lower your monthly payments for the debt and significantly reduce your total payments for the debt in question.
We should note here that in some cases, you may want to consider consolidating credit card debt with a lower interest rate card. However, most such cards come with an expiration date for the introductory rate, so make sure to read the fine print. If you can pay off the debt before the higher rate kicks in, it might be worthwhile to transfer your debt; if not, a home equity loan is a better option.
Bank loans
Any bank loan that has a high interest rate can be consolidated with a home equity loan provided you have enough equity to cover it. Such loans may include the following:
- Unsecured loans
- Car loans
- Student loans
You should keep in mind that while most student loans can be consolidated, private student loans and Direct PLUS loans are not eligible for consolidation. You will also want to compare interest rates. Some student loans have low interest rates and it never makes sense to consolidate debt at a higher interest rate.
Unsecured personal loans
If you’ve borrowed money from a family member, then you are allowed to use the funds from a home equity loan to repay them.
Since lenders typically send money directly to your creditors, you will need to have documentation of the personal loan.
Collection accounts
If you’ve had a past due utility bill or another debt sent to a collection agency, you may be able to consolidate it.
Some debt consolidation companies won’t allow utility bills if you still have an account with the company, but you can use the funds from a home equity loan for any purpose, including paying past due utility bills.
How much can you borrow with a home equity loan?
The amount you can borrow with a home equity loan depends upon the appraised value of your home and how much equity you have to borrow against.
It may be helpful to look at an example. Say you have a home that’s been appraised at $500,000 in today’s market. You bought the house for $450,000 and made a 20% down payment (that would be $90,000.) Since buying it, you have paid down an additional $50,000 of the principle.
For the purposes of this example, we’re not going to get into the details of interest and amortization. Here’s what your equity calculation would look like:
- Initial value: $450,000
- Down payment: -$90,000
- Principle payments: -$50,000
- Debt remaining: $310,000
With a current market value of $500,000, you would have $190,000 of equity, which works out to 38% equity.
Since most lenders want the combined debt between your mortgage and home equity loan to total no more than 80% of your home’s value, the above example would mean the maximum amount to be borrowed would be $90,000, leaving total debt of $400,000 on a $500,000 house.
We should note here that there are exceptions. If an Addition Financial member who had a mortgage with us wanted a home equity loan, we would lend up to a total loan amount of 90% of the home’s value to qualified borrowers. So, using the above example again, we could potentially lend an additional $50,000 against the home equity for a total debt of $450,000.
How do you get a home equity loan for debt consolidation?
The process to apply for a home equity loan is a simple one. Here are the steps to follow.
Take a financial inventory.
The first step is to take a financial inventory. This step should include the following actions:
- Total your debt and make notes about interest rates and the total amount to repay them.
- Check your FICO score. (Many lenders want to see a minimum credit score of 620 for a home equity loan, although some may be willing to work with you if your score is lower than that.)
- Compare your monthly income to your debt payments. You should take your total monthly debt payments and divide that amount by your monthly gross income. Many lenders want to see a back-end debt-to-income ratio of 36% or lower. (The back-end ratio uses all your debt payments, while the front-end ratio uses only your mortgage or rent.)
Checking these numbers should give you an idea of your ability to qualify for a home equity loan to consolidate debt.
Calculate your home equity.
The next step is to calculate your home equity, which you can do by checking Zillow or a similar site to see the current market value of your home.
Keep in mind that your home equity lender will order an appraisal of your home that will be used to calculate your equity. The reason to check it beforehand is to have an idea of what your equity might be and whether you have enough to qualify for a loan and use the proceeds to pay your debt.
Decide how much to borrow.
After you calculate your home equity, you can use your financial inventory to decide how much to borrow against it.
Keep lending limitations in mind and decide how much to borrow to pay your debt (or part of it) using your loan. We also suggest estimating the loan payment to make sure you can afford to pay it each month.
Choose a lender and complete your loan application.
It’s always a good idea to research lenders before you apply for a home equity loan. You’ll want to look at the lender’s reputation and loan terms.
For the application, you’ll need to submit pay stubs, bank statements, an asset statement and tax returns if you are self-employed or have income that’s not from employment.
Close on your loan and pay your debts.
The final step is to attend your loan closing to sign all necessary documents and wire funds to pay off your debt. In many cases, your lender will transmit funds directly to your creditors, which may include credit card companies, banks, credit unions and other entities.
Once your debt has been paid, you’ll make monthly payments on your home equity loan, which should be lower than your combined monthly debt payments before your loan. With each payment you make, you’ll be reducing your total debt and at the same time, you may also be improving your credit score.
If you have equity in your home and outstanding high-interest debt that’s become a concern, you may want to consider the option of taking out a home equity loan to consolidate your debt. Since many banks offer far lower interest rates than credit cards, you may be able to significantly reduce your monthly payments and save thousands of dollars in the long term.
Are you considering debt consolidation with a home equity loan? Addition Financial Credit Union is here to help! Click here to learn about our home equity loans and start the application process today.
Posted on Jan 19, 2023
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