Should I use home equity to pay off debts?
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America, we have a problem. According to the Federal Reserve Bank of New York’s Center for Microeconomic Data, total household debt reached a new peak in the fourth quarter of 2017, soaring to $13.15 trillion. Some of that growth can be attributed to mortgage debt, which rose 1.6%. But the biggest culprit is credit card debt, which grew 3.2% in the last quarter of 2017.
Despite growing consumer debt, homeowners might be feeling wealthier as they watch their homes – the largest financial asset for many people — increase in value. After all, the average homeowner saw their home’s value increase by 12.2%, or $15,000, in 2017.
On the one hand, you’ve got mounting high-interest credit card debt. On the other, you have equity in your home. Should you take advantage of relatively low mortgage interest rates and use your home equity to pay off that high-interest debt? The answer isn’t as simple as it might seem.
Understanding home equity
Home equity is the difference between the value of your home and your current mortgage balance. If your home is worth $300,000 and your mortgage balance is $200,000, you have $100,000 (or 33%) equity in your home.
You build equity in two ways:
- Pay down the principal balance of your mortgage so you owe less than the home’s value.
- The value of your home appreciates in value so that it is higher than your current mortgage balance.
Leveraging home equity to pay off debt
Home equity debt lets you access some of the equity in your home to make home repairs, pay college expenses, consolidate debt or cover other major expenses. They don’t replace the existing mortgage on your home like a cash-out refinance would. Instead, a home equity loan acts as a second mortgage on your home with its own interest rate and monthly payment.
If you decide to tap into your home’s equity to pay off debt, you have a couple options:
- Home equity loan (HEL). Home equity loans give you a lump sum to pay down debts. They’re typically fixed-rate loans with a fixed amount you’ll pay monthly.
- Home equity line of credit (HELOC). A HELOC is a revolving loan that uses your home as collateral.
“When faced with high-interest rates on debt such as payday loans or credit cards, any opportunity to refinance to lower rates should be considered,” Jeffrey Hensel, a mortgage broker with North Coast Financial in Oceanside, Calif., told LendingTree.
But Hensel prefers a HELOC over a HEL. “HELOCs are more convenient as the borrower can move money in and out of the credit line as needed,” he said. Also, interest is only charged on the amount you’re currently using, whereas with a home equity loan, you’ll pay interest on the entire loan amount for the duration of the loan.
Interest rates on a HEL are typically higher than on a HELOC, but because HELOCs are usually adjustable-rate loans; if interest rates rise, your payment and the cost of borrowing will go up as well.
How big of a loan can I get?
Your LTV compares the balance of your mortgage with the appraised value of your property. Using the example above, if your home is worth $300,000 and your current mortgage balance is $100,000, your LTV is 33%. If you were to borrow an additional $100,000 in the form of a home equity loan or line of credit, your combined loan-to-value (CLTV), which includes your first mortgage and the HEL or HELOC, would be 66%.
Most lenders require a CLTV of 85% or less for a HEL or HELOC.
What is needed to obtain a home equity loan or HELOC?
The documentation for a home equity loan can feel similar to the paperwork needed when you bought your home. Most lenders require proof of income and an appraisal to verify the value of your home.
While actual requirements vary by lender, in general, you should be ready to show:
- Two years of W-2s
- Two years of federal tax returns
- Two months of bank statements
- Two months of pay stubs
- Proof of other income such as tips, rental or investment income and Social Security benefits
- Explanation of any gaps in employment lasting a month or more
- Profit and loss statements for self-employed borrowers
- A copy of your most recent mortgage statement
- Amounts, payee names, billing addresses and account numbers for any debts you’ll plan to pay off with proceeds of the HEL or HELOC
- Proof of homeowners insurance
In addition, Hensel said lenders will use your documented income to evaluate your debt-to-income (DTI) ratio. DTI is all of your monthly debt payments divided by your gross monthly income. Lenders use this ratio to measure your ability to meet your monthly debt payments.
Hensel said lenders want to ensure that your DTI will remain below 45% after taking the new potential loan payment into account.
To illustrate, say your gross monthly income is $7,000 per month. You’re currently paying $1,500 per month toward your mortgage, $400 per month for your car loan, $300 per month on student loans and $500 per month toward credit cards for a total of $2,700 per month in debt payments. Your current DTI would be 38%.
If you planned on paying off your car loan, student loans and credit card debt with a home equity loan or line of credit, the lender would want to ensure your new debt payments, including your existing mortgage and the new HEL or HELOC, would be $3,050 or less. That will keep your DTI at or below 45%.
Should I use home equity to pay off debt?
Before you use your home equity to pay off debt, consider the pros and cons.
|Pros and Cons of Using Home Equity to Pay Off Debt|
|Secured by your home, so they generally offer lower interest rates than credit cards||Missed payments can put your home at risk|
|Loan limits may be higher than other consolidation options such as a personal loan or credit cards||Approval can take weeks|
|Simplifies your finances by consolidating multiple payments to a variety of lenders into one payment per month||Unless you take steps to curb overspending, you could wind up racking up more debt over time|
|May be able to lower your overall monthly debt payments||If home values decline, you could be “underwater” on the loan, meaning you owe more than the home is worth|
|Interest paid on a HEL used to consolidate debt is not tax-deductible.|
What to look for when using home equity loans to pay off debt
Using home equity to pay off debt may help you shed the burden of higher-interest student loan debt into a more manageable monthly payment, but it’s not enough to look solely at reducing your interest rate or monthly debt payments. Here are some other things to look out for:
How much will you actually save?
Remember, you’re not actually decreasing your total debt, just shifting it from one form to another. So you have to consider whether the decision will still cost more in the long term.
For instance, say Brian has $20,000 in credit card debt that he’s considering paying off with a home equity loan. He’s currently paying 16% interest on the credit card and making monthly payments of $400. If his interest rate and monthly payment remained the same, it would take Brian 6.9 years to pay off the balance on his credit card and cost him $13,177.77 in interest.
If Brian could refinance that credit card debt with a 15-year fixed home equity loan with a rate of 6%, he could reduce his monthly payment to $168.77. It would take him longer to pay the balance off, but he’d pay only $10,378.83 in interest, a savings of $2,798.94.
Brian could really benefit if he continued making that $400 per month payment, even though the required amount for the home equity loan was only $168.77. In that case, Brian could save an additional $7,304.48 in interest and pay off his second mortgage 122 months (just over 10 years) sooner.
The thing is, you need to run the numbers to see how much you can actually save in the long run. What if Brian had some credit problems and could only get a loan with a 7.5% interest rate and he couldn’t afford to make additional principal payments each month? In that case, he would still lower his monthly payment to $185.40, but over the course of 15 years, that loan would cost him $13,372.46 in interest – $194.69 more than he would’ve spent if he’d never refinanced.
Also, keep in mind that recent tax reform limited the deductibility of home equity debt. Prior the Tax Cuts and Jobs Act (TCJA), a homeowner could deduct up to $100,000 of interest on a HEL or HELOC, regardless of how proceeds of the loan were used. But as of Jan. 1, 2018, the interest paid on home equity debt is deductible to the extent that the proceeds were used to buy, build or substantially improve the home. In other words, if you tap your home’s equity to remodel your kitchen, the interest may be deductible. If the proceeds are used to pay off debt, it isn’t deductible.
This provision of the new tax law is set to expire in 2026. After that, assuming Congress doesn’t change the rules again, we’ll revert to the old rules.
How much are closing costs?
The scenario above doesn’t consider the cost of refinancing. While actual closing costs vary by lender, they typically run anywhere from 2% to 6% of the loan amount.
Even when lenders advertising “no-cost” HELs and HELOCs, there are always costs – you just don’t have to pay them out of pocket at closing. Instead, the lender may charge a higher interest rate or roll them into your new loan. When shopping for a loan, the loan estimate provided by the lender should disclose your estimated closing costs so you can factor them into your decision.
Is there a prepayment penalty?
If you’re planning on paying off your home equity loan quickly, watch out for prepayment penalties. Some lenders charge a penalty if you pay off your loan within the first three to five years.
The FTC issued a warning about unscrupulous lenders who try to take advantage of homeowners who are older, or have low incomes or credit problems. They caution consumers to be on the lookout for:
- Loan flipping. The lender encourages the homeowner to repeatedly refinance the loan, borrowing more each time. Each refinance incurs additional fees and points, thereby increasing your debt.
- Insurance packing. The lender adds credit insurance or other products to the loan that the homeowner doesn’t need.
- Bait and switch. The lender offers one set of loan terms when you apply, then pressures you to accept higher charges when the loan closes.
- Equity stripping. The lender approves your loan based on the equity in your home, not your ability to repay. If you can’t make the payments, the lender forecloses on your home.
- Nontraditional products. The lender may offer nontraditional products, such as loans where the minimum monthly payment doesn’t cover the principal and interest due, causing your loan balance to increase over time. Loans may also offer low monthly payments but require a large lump-sum (“balloon”) payment at the end of the loan term. If you cannot make the balloon payment or refinance, you could lose your home.
- Mortgage servicing abuses. The lender charges fees that are not allowed under the mortgage contract or the law. This might include exorbitant late fees or fees for insurance, even though you already carry insurance on the property.
- The “home improvement” loan. A contractor promises to arrange financing for a home repair or remodeling project. He begins work on the project, then tries to pressure you into signing paperwork for a loan with a high-interest rate or other fees. When you hesitate, he threatens to leave the project unfinished unless you sign.
What are some alternative options for paying off debt?
If you’re struggling to make your monthly debt payments, a home equity loan or line of credit isn’t your only option. Here are some alternatives you might consider:
All or part of your debt is transferred to another credit account, often with a low introductory interest rate.
Pros: You may be able to take advantage of a 0% APR intro rate and save on interest charges
Cons: May have to pay balance transfer fees
Borrow money from a bank, credit union, online lender or peer-to-peer loan. Personal loans are not backed by collateral.
Pros: Possibly the best option if you don’t have enough equity in your home to meet LTV requirements
Cons: Because personal loans are unsecured, interest rates are typically higher than home equity loans
Debt management plan
Work with a credit counseling agency to consolidate your bills into one monthly payment.
Pros: The credit counselor may be able to negotiate with creditors to reduce interest and penalties
Cons: You may be required to close your credit cards, which could lower your credit score
To get a better understanding of alternative options to pay off debt, you can visit this page
Still unsure of what to do?
Using your home’s equity to pay off high-interest debt may seem like the smart thing to do, but before you put your home on the line, ask yourself whether a HEL or HELOC will really solve your problems in the end. Significant high-interest consumer debt is often a result of poor money management and overspending. If you struggle to live within your means, using the equity in your home to pay off your debt may help in the short term. But if you find yourself racking up more debt on top of an extra mortgage payment, you’ll be worse off in the end.