If you have a large amount of home equity, you may consider using it to consolidate your debt. If you are drowning in debt, it can seem like a great idea. You get rid of the high interest debt and replace it with a home equity loan. While in most cases it can be a great idea, there are some instances when it doesn’t quite work out as planned.
Keep reading to learn the pros and cons of this process.
The Pros of Consolidating Debt With a Home Equity Loan
There are several reasons why consolidating debt with a home equity loan is a good idea, including:
- You’ll likely get a lower interest rate. Home equity loans have fairly low interest rates, especially if you have good credit and a low debt ratio. Your credit card debt and even installment debt may not have as low of a rate, costing you a lot more money in the long run.
- You only have one payment to make. If you have many debts that you have to write checks to each month, it can get overwhelming. The risk of forgetting a payment or making a payment late gets higher when you have a lot of payments to make each month. With a home equity loan, you make one payment and it covers all of the debts.
- You’ll know when the debt will be paid off in full. When you close on your home equity loan, you receive an amortization table. This table shows you how much principal and interest you pay each month as well as the principal balance of the loan. This way you can see the exact date that you’ll pay the debt off in full. You can even pay extra towards the mortgage and pay the debt off sooner.
The Cons of Consolidating Debt With a Home Equity Loan
Just as there are some good reasons to consolidate your debt with a home equity loan, there are some bad sides too:
- You put your house at risk. Credit card debt and personal loans aren’t secured. If you default on the debt, the creditor can’t take your home or any other possessions. Sure, they could slap a judgment on you, but that takes time and it still doesn’t take your home. If you default on your home equity loan, the lender can start foreclosure proceedings, causing you to lose your home.
- You could lose money on the deal. If the housing industry goes through another housing crisis or your home loses value for some other reason, you could be upside down on your home. This means you owe more than the home is worth. If you were to sell the home, you’d have to come up with money to make up the difference to pay the loan off in full.
- You open your credit cards up for more spending. If you consolidate your debt and truly want to stay out of debt, that’s one thing. If you know you can’t control your use of credit cards, though, you may want to think of another way to consolidate your debt. With credit cards wide open with no balance, it could be like an open invitation for you to rack them up with debt all over again.
Different Ways to Consolidate Debt
There are several ways you can wrap your consumer debt into your home loan. The traditional method is to take out a home equity loan or line of credit and pay the debt off with the proceeds of that loan. This means you’ll have a first and second mortgage that you must pay.
If you don’t want two mortgages, you can also refinance your first mortgage and take cash out of your home’s equity. This is called a cash-out refinance because you borrow a larger amount than your current principal balance. You can use the proceeds to pay off your debts. You then only have one mortgage payment to make each month.
If you opt for the cash-out refinance, watch your LTV. If you use a conventional loan and you borrow more than 80% of the home’s value, you will end up paying Private Mortgage Insurance, which adds to the cost of the refinance and may not make consolidating your debt worth it.
Consolidating your debt into your home loan can be a great way to free yourself from crushing debt, but you have to go about it the right way. If you can manage to keep yourself debt free and be diligent about your mortgage payments, you could see an end to the debt in years to come.