Should you use a home equity loan to consolidate your debt?

If you’re struggling to pay off your debts, taking out a home equity loan may be your best option to consolidate your debt. While this debt consolidation method is not for everyone, home equity loans provide lower interest rates and a tax deduction that can help overwhelmed borrowers get back on track.

The basics of using a home equity loan for debt consolidation

Home equity represents the difference between how much your home is worth and how much you owe the mortgage lender. This is one of any homeowners’ most valuable resources, because more home equity equals more access to cash, loans, and lines of credit. For example, if your house is worth $200,000 but you owe $100,000 on the mortgage, you could potentially borrow up to $100,000.

Home equity loans are a type of secured loan that require borrowers to use their house as collateral. Borrowers can use home equity loans to pay off high-interest debts, such as credit cards and student loans, at a lower interest rate. So if you’re willing to tap into your home equity, you can use it to consolidate your debts into one monthly payment with a lower interest rate.

How home equity loans work for debt consolidation

When considering a home equity loan for debt consolidation, it’s helpful to think of it as a "second mortgage." Once the loan is approved, the lender will provide a lump sum payment that’s equal to the allotted percentage of your home equity. You can use the cash loan to make lower-interest payments on your consolidated debt.

From there, you’ll be responsible for making mortgage payments on the home equity loan in addition to your original mortgage payments. Keep in mind that the new repayment period is typically shorter than the first mortgage.

Pros of home equity debt consolidation

• One simple payment: The primary benefit of any debt consolidation method is simplifying multiple monthly payments into one, streamlined payment. Paying down your debts through a monthly home equity loan payment decreases the likelihood of forgetting a payment.
• Lower interest rate: Home equity loans provide lower interest rates than other types of loans because the funds are secured against the value of the borrower’s home. Lower interest rates may allow borrowers to pay off their debts faster because they are paying less in interest than they would have otherwise.
• Qualify with a lower credit score: Since home equity loans are backed by the collateral of the borrower’s home, their credit score is less critical to the lender’s approval. Lenders will review a host of other qualifications, such as your debt-to-income-ratio, income, and payment history. However, before applying, research the credit score requirements of your loan lender.
• Tax deduction: Another bonus of using a home equity loan for debt consolidation is that the loan’s interest can be tax deductible. When it comes to getting out of debt, every dollar counts!

Cons of home equity debt consolidation

• Your house is collateral: The bottom line is that putting up your home’s equity as collateral for debt consolidation is incredibly risky. If you default on the home equity loan, you may face foreclosure on your home. Borrowers should seriously weigh this risk against their ability to make on-time payments before applying for a home equity loan.
• It will take longer to pay off your mortgage: Since you’ll have to pay off the home equity loan faster than the original mortgage, it may extend your loan payoff timeline. Plus, if the spending problems that led to debt consolidation continue, you’ll be piling new debts on top of old ones.
• You may be at risk of creating negative equity: Negative equity is when you owe more to the mortgage lender than the house is worth. Since home equity loans are based on the value of the home, any decrease to the home’s worth could cause the borrower to go "underwater" on both the house and the loan.

Alternative debt consolidation methods

By now, we’ve established that while there are benefits to using home equity loans for debt consolidation and there are some serious risks involved. Luckily, there are several other debt consolidation methods that have proven to be equally – if not more – effective.

Debt consolidation loans

Debt consolidation loans are a type of personal loan that allows borrowers to take out a new loan to pay off multiple unsecured loans, such as credit cards, student loans or other non-mortgage loans.

Instead of requiring borrowers to put down collateral, debt consolidation loans provide funding based on their credit and financial history. Borrowers can apply for this type of loan through banks, credit unions and online options, including Rocket Loans^SM which could approve and fund the loan as soon as the same day.

Cash-out refinance

Cash-out refinance is another popular tool for debt consolidation because it’s based on your original mortgage. In comparison to using a home equity loan a cash-out refinance is less risky and provides better interest rates. With this option, borrowers can work toward becoming debt-free without taking out the equivalent of a second mortgage. You can apply for a cash-out refinance online today through our trusted sister company, Rocket Mortgage^®.

Balance transfer credit card

Another option for consolidating debt is to apply for a balance transfer credit card. A balance transfer credit card allows you to move multiple outstanding debts to a credit card with a lower interest rate. Almost every credit card company grants balance transfers, and most extend low-interest introductory or 0% APR offers to borrowers with satisfactory credit.

The key to balance transfer credit cards is to pay off the majority of the total balance before the promotional period ends and the interest rates increase. Don’t forget to account for the card’s balance transfer fees, which can run up to 5% of the amount transferred.

The bottom line: You have options for consolidating debt

If you’re interested in consolidating your debts, there are several different options to consider. Evaluate the above risks, benefits, and criteria when deciding whether a home equity loan is the right debt consolidation method for you.

And if not, take a look at less-risky options, such as debt consolidation loans or cash-out refinancing. And when you’re ready to take the first step toward buttoning up your credit and achieving more, apply for a Rocket Loans debt consolidation loan today.