Home Equity and HELOC for Debt Consolidation: Is it a bad idea?

Some facts to consider...

Are you really close to the maximum spending limit on your credit card? Are multiple outstanding debts putting your FICO score in distress? Even dedicated finance experts sometimes find it challenging to manage numerous loan payments every month to different credit card companies and individual lenders. Calculating the varying interest rates, penalties and making the payments to several vendors before deadline becomes more than a chore when you have multiple debts to pay off.

In such situations, smart citizens often turn to debt consolidation loans for help.

Consolidating debt involves the combination of several debts including your credit cards, payday loans, medical bills and other short-term unsecured debts to one monthly bill. A debt consolidation loan is a new loan a person takes out to pay off the total outstanding debt. So, the person now has only one new debt to pay off. The ideal consolidation loan should have a fixed and low-interest rate, which simplifies the debt situation.

Does HELOC help with the consolidation of loans?

Today, several companies offer debt consolidation loans at varying interest rates that depend on the applicant's FICO score and credit history. While that is great news for those with an excellent or good credit score, it makes getting consolidation loan at amicable interest rates quite tricky for those with poor credit scores. A practical solution in such situations is consolidating high-interest debts against a home equity line of credit (HELOC).

Today, consumers turn to HELOC for two prominent reasons –

i. Consolidation of existing high-interest debts
ii. Renovating their home

Home equity lines of credit for debt consolidation helps the applicants secure lower interest rates and more amicable APR than other lines of credit.

What is HELOC?

HELOC provides the borrower with a new secured line of credit. He or she can draw funds from the HELOC as and when necessary. It is similar to a credit card so that the user can pay off the loan amount monthly. Since the user may not be utilizing the entire credit limit, he or she only needs to pay off how much he or she withdraws. However, before taking out a new line of credit on your home equity, you must remember that you will be borrowing
money against your home. Therefore, failure to make timely payments can result in the foreclosure of your property.

What is home equity?

The available home equity is the difference between the fair market value of your home and any lien or mortgage you may have on it. For example – if your home has a value of $250,000 and you have a $200,000 mortgage on it, you have $50,000 worth equity. As a result, many borrowers refer to HELOC and home equity loans as a second mortgage.

Nonetheless, they are quite useful in the consolidation of multiple debts at different interest rates.

How is home equity different from HELOC?

A home equity loan can also help those with multiple outstanding loans. It is similar to a HELOC, except the borrower gets a lump sum at one time, instead of gaining access to a revolving line of credit. Since the borrower receives the entire amount at one go, he or she has to pay off the entire home equity loan within the repayment period at a fixed interest rate.

Whether you are considering a HELOC or a home equity loan to pay off your existing debts, there are specific pros and cons you should know.

What are the advantages of HELOC and home equity?

Here are the several benefits of using a HELOC or home equity for debt consolidation –

i. You will have to make one payment only
You may have several outstanding bills including credit card bills, medical bills, car loans, and personal loans. Consolidating against your home equity will bring the number of payments to just one per month.

ii. You will have a better idea of the debt timeline
Your credit cards can make reining in your debt quite challenging. They are open lines of credit. Therefore, you can keep using them as you pay off the existing debt. Become completely debt-free is almost impossible when you have multiple lines of credit within your arm's reach.

On the other hand, when you take out a home equity loan or HELOC, you have a fixed amount that you need to pay off by the end of three months or six months (depending on the repayment terms). In short, you have a targeted date by when you can be entirely debt-free. It can help you set real short-term financial goals.

iii. Interest rates on HELOC and home equity are low

Debt consolidation is not easy for everyone, and different lenders offer different interest rates. Taking out another unsecured loan to pay off existing lines of credit can be expensive due to the considerably high-interest rates. For example, the average interest rate on variable interest rate credit cards was close to 17.32% as of September 2018. On the other hand, the average interest rate on home equity loans for debt consolidation was a measly 6%. That ensures that a more significant part of your monthly installments pays off the principal rather than the interest.

iv. Home equity consolidation loans can save money

Although HELOC does not have a fixed rate of interest, it is considerably low and comparable to home equity loans. Making minimum payments on credit cards, or consolidating debt on other lines of credit can be more expensive than making the minimum payments on home equity loans. Check out the debt consolidation calculator and current interest rates on Nationaldebtrelief.com to find out how much you can potentially save by taking a home equity loan for paying off your existing lines of credit.

What are the drawbacks of HELOC and home equity?

Fixed interest rates, low interest rates, single monthly payments, and low monthly payments – they all sound great. Like every other consolidation method, HELOC and home equity loans have drawbacks as well. You should know the cons of both before you begin applying –

i. It is a time-consuming process
Applying for a new loan and receiving the money might take some time, but that is not the lengthiest of all processes. Paying off a HELOC or home equity loan that one might take out to pay off consolidated loans is the most time-consuming of them all. As we have mentioned before, people refer to these loans as second mortgages on homes. Therefore, the paperwork is quite extensive as well. Those, who don’t have much time in hand, might benefit from taking out another low-interest personal loan.

ii. The risks are considerably high

The new loans offer reduced interest rates against the security of your home. Since your home is the collateral, not paying or missing payments can have severe consequences. Many people have experienced the risk of losing their homes after defaulting on HELOC and home equity loan payments. Only those who are confident about making the payments on time should move forward with home equity and HELOC loans.

iii. Weigh in the closing costs and fees

Check with your lender about the appraisal fees and closing costs of the new loan. The charges vary from one lender to another. Therefore, when you are looking at potential home equity loans and HELOCs, always speak with a
company representative regarding their closing fee and appraisal fee. Take all the costs into account before you close a deal. The appraisal costs and closing costs will influence the net payment.

iv. Pay attention to the tax benefits

Earlier, it was possible for a homeowner to deduct the interest of a HELOC or home equity loan from their taxes. After the 2018 tax reform bill, the situation has changed quite a bit. The borrower can only deduct the interest on such loans only when he or she uses the money to build, renovate or buy. All uses of HELOC and home equity loans to pay off credit card loans and consolidated loans are not tax deductible. To learn more about tax benefits, you should consult with your tax attorney before signing up for the new loan.

What are the alternatives to home equity or HELOC for debt consolidation?

If you currently don't qualify for a low-interest HELOC or home equity loan, you can still consolidate your existing debts. If you have a significantly smaller debt load, you can try taking out a small personal loan at a low interest rate, or you can utilize a 0% balance transfer credit card. Both these options are viable for debtors with a small burden of debt. 

Pay off all existing debts using the credit card and Make use of the introductory, 0%-interest period on the balance transfer credit card to pay off the debt. Even personal loans have lower interest rates than conventional credit cards. Small personal loans (both secured and unsecured) are quite helpful for people with decent or average credit scores and multiple open lines of credit.

When is taking out a home equity loan or HELOC for debt consolidation a bad idea?

Taking out a new loan to pay off several existing lines of credit sounds simplifying and attractive. However, that might not be the solution for those with a spending problem. A home equity consolidation loan or HELOC is not the silver bullet that vanquishes all outstanding debts. If you have poor financial management, you will always find yourself in a sea of unpaid bills with a pittance left in your savings accounts. Adding a new line of credit will merely increase the burden of debt. Taking out a home equity loan or HELOC to pay off existing debts is only a bad idea if you cannot meet the payment deadlines or if the outstanding debt is too insignificant compared to your home equity.

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