Curious about using a home equity loan to pay off debt? Keep reading to learn how to properly use a home equity loan for debt.
From credit cards to student loans, some kinds of debt carry a higher interest rate and impose a heavier burden than others. If you’re a homeowner looking for ways to lower monthly payment amounts on your debt or seeking options for debt settlement, you may be interested in home equity loans.
Using a home equity loan to pay off debt boils down to a process of applying for the loan, waiting for approval, receiving the disbursed funds, and then using it to pay off outstanding debt. Although it is important to remember the difference between debt consolidation vs home equity loan, you can actually use your home equity loan for debt consolidation.
However, each step requires careful consideration to avoid financial pitfalls and smartly leverage your home equity.
In this guide, we’ll explain the process, its benefits and pitfalls, and your other options for paying off debt.
What Is a Home Equity Loan?
Before signing the dotted line on a home equity loan, it’s important to understand what you’re signing up for. It’s equally crucial to check your credit report before embarking on this journey, as you might not be able to get a home equity loan with bad credit.
A home equity loan is a type of second mortgage that refers to a secured loan based upon and secured with home equity. Calculate your home’s equity by subtracting any remaining mortgage balance from its current market value. This gives you an idea of the loan amount you can expect, minus the closing costs. If you were to sell your home, this amount is what you would walk away with from the sale.
- Your home equity exists but remains unavailable in the immediate term, unlike the cash in your bank account.
- When signing for a home equity loan, you offer your home equity as collateral to the lender in return for liquid funds.
Lenders determine loan disbursement amounts on your home equity, typically restricting them to an upper limit of 85%. Because the debt is secured against your home, it will often carry a lower interest rate than your existing debt. Be sure to learn more about a home equity loan vs second mortgage, as it’s not your only option.
The Risk of Home Equity Loans for Paying off Debt
The primary risk with home equity loans remains using your home as collateral.
If your home’s value drops on the market, you may owe more than it is worth which makes the issue of debt even worse.
If you cannot meet your loan repayment obligations, you may lose your home to foreclosure.
The Process of Using a Home Equity Loan to Pay Off Debt
Is a home equity loan a good idea, and is it right for you? That all depends on the terms of the loan and your long-term financial goals. To get more information from potential lenders, you’ll need to start shopping.
The entire process of how to pay off debt with a home equity loan can be broken down into five steps:
- Research and compare – Potential applicants should first compare terms and rates offered by different lenders. Do not be afraid to make it known that you are shopping around for loans, as it may help your offers.
- Application – Applying for a home equity loan resembles the efforts you made to secure your initial mortgage. You may also need to have your home appraised as part of the application. You will need to undergo or provide:
- A credit check
- Proof of your income
- The property’s estimated value
- The remaining amount owed on your mortgage
- Monthly mortgage payment
- Paycheck stubs
- Last year’s tax return
- Bank statements
- Property taxes
- Homeowners association fees
- Insurance coverage
- Approval – Lenders typically reject applications due to a too-low credit score or too little equity. The threshold is high and may require a credit score of 650 or more and home equity of at least 15-20%. Approval may also depend on your debt-to-income ratio (DTI), which is your minimum debt or interest payments to gross income per month. The lower your DTI is, the better approval chances are.
- Disbursement – There remains a three-day cancellation period even after a home equity loan is signed, during which you may change your mind for any reason. After this period, the lender disburses the loan funds.
- Payment (and repayment) – Once receiving the loan funds, you can use them to pay off debt (or other expenses). You will also need to meet your agreed-upon monthly payment plus interest.
Home Equity Loans vs. HELOC for Paying off Debt
The loan term home equity loan typically refers to lending agreements where the funds are disbursed in one lump sum and repaid with fixed monthly payment amounts and interest over a set loan term.
HELOC, or Home Equity Line of Credit, provides homeowners with a revolving line of credit they can borrow against at variable interest rates. HELOC functions something like a credit card with your home equity determining your limit. Homeowners have the option of using HELOC to pay off mortgages or settle other debts.
Ask Yourself if a Home Equity Loan Is Right for You
Before undertaking the process to secure a home equity loan, evaluate whether it is the right financial decision for your situation.
When It Makes Sense to Use a Home Equity Loan to Pay Off Debt
Home equity loans can be a good decision when used to pay off debts:
- From home renovations
- From brief periods of financial hardship
- For debt consolidation
Renovations can be costly, but these projects also add value to your home, increasing your equity. Home improvements also remain the only tax deduction you can claim. The IRS no longer allows deductions on home equity loan interest unless the proceeds were used “to buy, build, or substantially improve your home.” For this reason, many choose home equity loans for home improvement financing.
Repaying debts proves to be a good use for a home equity loan if they were incurred over a brief period and your financial position is otherwise stable. The lump-sum disbursement and lower interest rates of home equity loans can help consolidate and save money on credit card debt repayment.
When Home Equity Loans Aren’t the Best Option
The strict minimum requirements for home equity loans generally limit this option to applicants with exceptional financial records. Due to the application fees that must be paid regardless of approval, it does not make sense to pursue a home equity loan if your approval chances are low. In which case, it may be better to learn how to consolidate debt with bad credit.
In the past, a denied application might mean selling your home to access your equity as a last resort—with the added challenges of moving.
Even if you don’t qualify for a home equity loan, alternative options exist for you to learn how to get equity out of your home.
Sale-Leaseback—An Alternative to Home Equity Loans
A sale-leaseback program can provide financial solutions that allow you to convert your home equity quickly. Rather than taking out a debt consolidation loan, debt consolidation refinance, or personal loan, sale-leaseback solutions include selling your home while continuing to reside in it under lease or rental agreements.
Utilizing a sale-leaseback solution can help you achieve financial freedom by converting your equity now, without repayments.
If you’re curious about using a home equity loan to pay off debt, especially as an alternative to options like a cash out refinance or home equity line of credit, talk to a financial expert about how to properly use a home equity loan for debt and about what potential alternatives may work better for your situation.
- Experian. How Does a Home Equity Loan Work?
- FTC Consumer Information. Home Equity Loans and Credit Lines.
- IRS. Publication 936 (2020), Home Mortgage Interest Deduction.
- MoneyGeek. Guide to Home Equity Loans: Pros & Cons, Requirements & Limits.