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What To Know About Home Equity Loans For Debt Consolidation

Jul 24, 2024

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Are you in debt and needing to find a way to simplify your payments? A home equity loan for debt consolidation could be the answer. You can borrow on your home’s equity to pay off bills and revolving debts such as credit cards and non-mortgage loans. But what are the pros and cons of using a home equity loan to pay off debt, and are other solutions worthy of equal consideration?

Before you make any decisions about your home equity and debt consolidation, it’s important to be fully informed.

Using A Home Equity Loan To Pay Off Debt

A home equity loan is a second mortgage that allows you to get your money in a lump sum. The amount you’ll be able to borrow will be smaller than your original mortgage since lenders rarely let borrowers cash in on 100% of their home’s equity. The repayment period on a home equity loan is also usually short compared to your original mortgage.

You can use your home equity loan for virtually anything, and that includes debt consolidation. Home equity loans typically have a fixed interest rate.

How Does Debt Consolidation Work With A Home Equity Loan?

Once your lender closes your home equity loan, they’ll send your lump-sum payment. Shortly after receiving your funds, you’ll begin making monthly payments on your loan while continuing to make your primary mortgage payment each month. Since mortgages – including second mortgages – usually have a lower interest rate than you’ll find on credit cards and personal loans, many homeowners use a home equity loan to consolidate higher-interest debts.

For example, you might take out a home equity loan to tackle credit card debt. Maybe you use a home equity loan with a 6% interest rate to pay down the debt on your 18% interest rate credit card and end up paying less in interest over the long term.

Rocket Mortgage® is now offering home equity loans for primary and secondary homes.

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Pros And Cons Of Using Home Equity To Consolidate Debt

Tapping into your home equity to consolidate debt carries with it both some pros and cons.

Pros

Here are the main advantages of using a home equity loan for debt consolidation:

  • You’ll have a relatively low interest rate. Because your home serves as collateral for the lender if you default on home equity loan payments, you’ll have a lower interest rate than you would with a loan that’s unsecured.
  • The credit score requirement is flexible. Since you borrow on the equity you own in your home, you typically don’t need a sky-high credit score to get a home equity loan. Check with your lender, as the minimum score for loan approval will vary depending on the loan product and other lender requirements.
  • You may get a tax deduction. The interest you pay on a home equity loan may be tax-deductible.

Cons

Here are some disadvantages commonly associated with using a debt consolidation home equity loan:

  • Your home acts as collateral. When you use your home as equity, you risk the roof over your head. In other words, your lender could repossess your home if you don’t repay your loan as scheduled.
  • The home value could change. If you borrow on your home’s equity and the value of your property decreases, you could owe more than your home is worth.
  • You stretch your timeline. By adding a second mortgage to the mix, you take on more overall debt and may extend the amount of time it takes to pay off your original mortgage.

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Who’s Eligible For A Home Equity Debt Consolidation Loan?

Before approving you for a home equity loan, your lender will analyze your equity, credit score and debt-to-income ratio (DTI). You’ll typically need at least 15% – 20% equity in your home, a credit score of at least 620 and a DTI of less than 50%, but requirements vary by lender. The amount you can borrow with a home equity loan depends largely on the lender and the amount you have in equity.

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Should You Use A Home Equity Loan To Consolidate Debt?

For most people, their home is their most valuable possession. You may work 15 – 30 years to pay it off, so be cautious when deciding if a home equity loan is a good idea. Some financial experts recommend using your home’s equity only for emergency situations, such as unexpected medical bills.

Think carefully about the ultimate purpose a home equity loan for debt consolidation would serve. Consider your future goals, other financial aspirations and whether you plan to stay in your home for the long term. All these factors, and others, could affect your decision.

How To Apply For A Home Equity Loan To Consolidate Debt

Once you’ve carefully weighed your financial needs and debt obligations and you’ve decided to take equity out of your home, some next steps are in order.

Step 1: Determine How Much Equity You Have In Your Home

Before you apply for a second mortgage, it’s important to calculate the amount of equity you have in your home. You’ll do this by subtracting the amount you still owe on your mortgage from the appraised value of your home. Keep in mind, though, that you’ll typically only be able to access 80% to 85% of your home’s value in cash – again, minus the amount you still owe on your primary mortgage. 

From there, you can determine whether the amount available to you in a home equity loan is enough to cover the outstanding debts you’d like to consolidate.

Step 2: Check Your Credit

A strong credit score can help borrowers obtain a second mortgage that’s more favorable to their wallet.

If you don’t meet the minimum credit score needed for a home equity loan, talk with your mortgage lender or take small, actionable steps to get your credit score up to par. The minimum credit score and other requirements you’ll need to meet will depend on your lender.

Step 3: Compare Loan Options

Compare home equity loan options from different lenders and select one with conditions of the loan (interest rate, monthly payment, length of repayment, etc.) that best suit your situation. Once you’ve considered the options, decide which one you want to pursue. Consider working with a financial advisor who can help you determine the best path forward.

Alternatives To Using A Home Equity Loan As A Debt Consolidation Loan

Some traditional alternatives to a home equity loan may be a better option for debt consolidation in some cases. These other methods, as well as the benefits and drawbacks of using them for debt consolidation, are worth a look.

Home Equity Line Of Credit (HELOC)

A home equity line of credit is similar to a home equity loan, but you receive funding as a line of credit instead of a lump sum. With A HELOC, you can borrow up to 85% of your home’s value minus the amount you owe on your primary mortgage. A HELOC is a lot like a credit card because you can carry a balance from month to month, but unlike a credit card, you can make interest-only payments during an initial period known as the draw period.

A HELOC, which usually has a variable interest rate, can be appropriate for debt consolidation because you don’t have to use the entire amount you’re allotted. And you’ll only have to pay interest on the amount you spend, not the total line of credit. Consider all the pros and cons of HELOCs before applying.

Rocket Mortgage doesn’t currently offer HELOCs.

Cash-Out Refinance

A cash-out refinance features some of the same benefits as a home equity loan but offers some advantages that home equity loans don’t. For example, you’ll only have one mortgage against your house. 

A cash-out refinance can be a wise debt consolidation strategy because it’s based on your primary mortgage and poses less of a risk to your lender. As a result, you’ll get a mortgage rate that’s low relative to most other options.

Personal Loan

A personal loan for debt consolidation could allow you to reap the benefits of a low interest rate compared to a credit card. If your personal loan is unsecured, which is usually the case with a personal loan, the rate you get will depend on your credit profile and financial history.

Look for a personal loan that doesn’t come with a prepayment penalty so you won’t be charged extra if you pay off your balance early. Also, if you extend personal loan payments past your designated repayment period, you’ll pay additional interest.

0% Balance Transfer Card

A 0% balance transfer card allows you to move all your existing debts to a card that has a promotional period of 0% interest. This period usually lasts 12 – 18 months, so ensure you have a plan in place to pay off your debts before this period ends.

You may be required to pay a transfer fee on some cards, so double-check the conditions of the loan.

401(k) Loan

A 401(k) loan allows you to borrow from your retirement fund. A 401(k) is an employer-sponsored savings plan that lets you set aside pre-tax dollars from your paycheck for retirement. A 401(k) loan is still a loan – you’ll typically have to repay the amount you borrow, plus interest, no more than 5 years after taking out the loan.

A 401(k) loan doesn’t impact your credit score, but failure to repay it could leave you in more debt than when you started. You could also risk your retirement savings and be subject to tax penalties if you can’t repay what you borrow.

The Bottom Line: Debt Consolidation With A Home Equity Loan Can Be A Good Option

It’s possible to consolidate debt in several ways. Compare your financial situation to the criteria previously discussed to decide whether it makes sense for you to borrow against your home’s equity in the form of a home equity loan. If not, another method of debt consolidation – such as a cash-out refinance, personal loan, 0% balance transfer card or 401(k) loan – may be the way to go.

Find out how much debt you owe and select the financing method that allows you to consolidate your debt with the least amount of risk.

Interested in tackling your debt with a second mortgage? To get started, learn more about home equity loans with Rocket Mortgage.

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Victoria Araj

Victoria Araj is a Team Leader for Rocket Mortgage and held roles in mortgage banking, public relations and more in her 19+ years with the company. She holds a bachelor’s degree in journalism with an emphasis in political science from Michigan State University, and a master’s degree in public administration from the University of Michigan.