How to use a home equity loan for debt consolidation

There are different types of home equity loans may be used for debt consolidation. (iStock)

Struggling with debt? If so, the equity in your home could be the secret weapon to strategically reducing your debt burden this year.

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What is a home equity loan?

Home equity is the difference between the market value of your home, and the amount owed on the mortgage. For example, you own a home worth $400,000, bought it 10 years ago and now only owe $200,000 on your mortgage. This means you have $200,000 in equity in the home.

Equity in the home can be built through paying down the mortgage, organic increases to the overall property value and home improvement projects.

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How does a home equity loan work?

A home equity loan allows consumers to borrow against any equity they’ve built in the property. Home equity loans are typically easy to obtain, especially in a low-interest rate climate. Keep in mind: most lenders will only allow consumers to borrow up to 80 to 90 percent of the home’s total value.

There are three different types of home equity loan products.

Traditional

Traditional home equity loans are often referred to as second mortgages because they act as a second loan that you pay back in monthly installments in addition to your primary mortgage payment. With a home equity loan, you have a fixed interest rate and fixed monthly payment.

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For example, you take on a home equity loan in the amount of $50,000. You get the $50,000 upfront in a lump payment and use it to pay off all outstanding credit card debts. Each month in addition to your monthly mortgage payment, you also make a monthly payment on the second mortgage loan of $50,000.

Home equity line of credit (HELOC)

A home equity line of credit, also known as a HELOC, functions differently than a traditional home equity loan. Rather than one lump payment, HELOCs provide access to a line of credit, which homeowners can draw from over a set period of time. HELOCs allow homeowners to only borrow what they need in case they end up needing less money than anticipated. Typically, these come with variable interest rates.

Cash-out Refinance

A cash-out refinance allows homeowners to tap into home equity by taking on a completely new mortgage in the amount of its current value. The new mortgage is then used to pay off the previous mortgage, and the homeowners bank the difference. Then, each month the homeowners make a payment on the refinanced amount.

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For example, you take on a cash-out refinance loan at $400,000. Your current mortgage is $200,000. You pay off the $200,000 put the leftover $200,000 in the bank, but each month you have a higher monthly payment because you’re now paying down $400,000 instead of the previous amount.

Should I use home equity to consolidate my debt?

Using home equity for debt consolidation makes financial sense because home equity loan rates are substantially lower than credit card interest rates. Because of this, using home equity consolidates debts into one payment while helping consumers pay less in interest over time.

Home equity loans also provide the added benefit of interest deductions at tax time, and homeowners may see a boost in their overall credit score.

While home equity sounds like an easy, no-fail solution to debt, borrowers should exercise caution. Taking on home equity debt can be tricky, particularly for those who have chronic spending issues. For one, if you fail to repay home equity loans, you can lose your home. Leveraging home equity for debt payoff also means you won’t be able to use it for other important money moves such as financing a child’s education, improving the home, or emergency expenses.

There are other ways to consolidate debt outside using home equity, like via 0 percent balance transfer offers or personal loans, for instance.

There’s also the tried-and-true approach of paying off debt with tight budgeting, cutting personal expenses, and using the debt snowball or debt avalanche methods. While it may take longer to pay off debt, at least your home won’t be on the line.