How to Use Your Home Equity to Pay Off Debt
If you are Click on the numbers to find out how pay the bill, you may not see it a great source of help: your home.
Borrowing against your home equity — or the difference between your home’s value and how much is left on your mortgage — can be the key to consolidating debt and ultimately saving you a ton in interest.
Even though housing prices have moderated, homeowners in the US are sitting at historically high levels of equity, with the average mortgage holder having about $300,000 in equity. That’s right as Americans are also eating up credit card debt. The average credit card balance is now more than $6,500, according to TransUnion data.
The result is a multiple of interest on the home equity products, especially home equity lines of credit or HELOCs. These products, sometimes called second mortgages, allow you to borrow and use money up to a certain credit limit, then repay the money on a schedule agreed between you and your lender.
Read about the pros and cons of using HELOCs as a debt consolidation tooland how to use the equity in your home to pay off your debt.
The pros and cons of using a HELOC to pay off your debts
If you’ve built up a large amount of debt, especially high-interest debt like credit card balances, a HELOC can be useful for getting lower interest rates. Rates on HELOCs today it starts at around 6% to 7%— much lower than the average annual percentage rate (APR) on credit cards, which is more than 22%.
Because HELOCs don’t usually give you a lump sum payment, they also offer more flexibility than other types of loans. These products are revolving lines of credit, which means you can take out cash as needed up to the total approved amount and control how much credit you accumulate. You only pay interest on the amount you have taken out of your credit line.
There is also flexibility about how you use a HELOCas there are no restrictions on what you should deposit. (Home equity loans, a cousin of the HELOC, work similarly but are distributed as a lump sum, and you’ll start paying interest on the full amount immediately.)
Also, the interest is paid on the HELOC can be deducted from your taxes starting this year – regardless of how you used the money received. (This is a change from a few years ago, when borrowers had to spend the proceeds on home projects to qualify for the deduction.)
Like most financial products, HELOCs come with downsides, too.
“You’re borrowing against your home equity and you’re putting your home up as collateral, so in the worst case scenario, the lender is responsible for your home,” says Glenn Downing, founder and principal of investment advisory firm CameronDowning. “You’re putting your family home on the hook.”
And if the value of that home goes down, you could end up with more debt than you need.
Some lenders offer fixed-rate HELOCs that are ideal for debt consolidation as you will have a predictable payment. But often, HELOCs come with variable interest rates, which means you may not be able to lock in a low fixed rate and may have to deal with fluctuations in your expected payments. Translation: You’ll pay more if interest rates rise.
HELOCs can also make it tempting to take on too much debt. You can usually get a HELOC worth up to 85% of your home equity. That means if you have $150,000 worth of equity, you can access a line of credit for up to $127,500 — more than you might need to pay off your high-interest debt. Mike Miller, a financial advisor at Integra Shield Financial Group, says he regularly asks clients interested in HELOCs. why they need that extra money.
“There may be some problem with spending,” Miller said.
How to use a HELOC to pay off your loan
When you use a HELOC or home equity loan to consolidate your debt, you are essentially borrowing from one source (your home) to pay off other, more expensive sources of debt (such as your credit cards).
When you first get a HELOC, your lender will determine how much of your mortgage you can borrow. During this first step, be prepared to pay some upfront costs such as application or initiation fees – although some lenders may waive these fees or include them in a line of credit.
After your loan is funded, you can start using it during a period called the loan period or drawdown period. You may be required to take out an initial amount or borrow a smaller amount each time you take out your money, depending on the terms outlined in the HELOC agreement. As soon as you get the cash, you can start paying off your most expensive debts.
Typically with a HELOC, you use the money as needed; that can make HELOCs useful if you want the flexibility to start consolidating your debts and then have some access to additional credit in future years. In fact, Miller says he’ll sometimes encourage clients to set up a HELOC even if they don’t plan to spend the money immediately, depending on their situation.
“It’s like an emergency fund,” he adds.
If, on the other hand, you know you only want to spend the money one time credit card debt paymentyou may be better off with a home equity loan than a HELOC. With this loan, you can borrow exactly what you need to pay off your higher-rate balance, and start paying off the lower-rate loan faster.
Over the course of the HELOC loan term, which typically lasts five to 10 years, you can pay back either principal and interest, or just interest. Of course, in this case, the goal of using a HELOC is to make it easier to pay off your debts. To avoid repeating when you are faced with unaffordable payments again, it is better to pay more than just interest so that your payments do not go out on the street.
Once the grace period is over, it’s time to enter a “payment period” where you will pay off the loan, usually between 10 and 15 years, or pay off the entire balance, depending on your agreement. You can pay off your HELOC early, although your lender may charge you a prepayment penalty.
More from Mali:
6 Ways to Pay Off Debt Fast
Debt Snowball vs. Debt Avalanche: Which Repayment Strategy Is Right For You?
How Does Debt Consolidation Affect Your Credit?
