If you are a homeowner who has taken on too much debt, a financial product known as a home loan can help you escape it.
Although taking out a home loan can be risky – after all, your home is used as collateral on the loan – the interest rates on the product are typically lower than credit cards or personal loans.
“As long as you have a steady income and know you can get the loan back on time, the lower fixed rate home loan is a sensible choice,” said Richard Ortoli, co-founder of New York law firm Ortoli Rosenstadt LLP. “However, it is important to make all payments on time to avoid putting your home at risk.”
This is how you can determine whether a home loan is the right choice for debt consolidation.
What is a Home Loan?
“A home equity loan is often viewed as a second mortgage and is a flexible loan for your home that is usually on top of your existing mortgage,” says Alex Klingelhoeffer, wealth advisor at national advisory firm Exencial Wealth Advisors. Here is a hypothetical example from Klingelhoeffer:
- Bought home for $ 250,000 in 2015
- $ 50,000 deposit.
- Five years later, in 2020, the house is now valued at $ 350,000.
- $ 180,000 balance on mortgage
- From 2020, in this example, the equity the property is now $ 170,000.
- “Banks allow you to borrow money at that value [the equity] via a home equity loan or a home equity line of credit (HELOC), ”says Klingelhoeffer.
Both home loans and HELOCs use your home’s equity to enable you to borrow money. However, HELOCs work more like credit cards. While home equity loans allow borrowers to withdraw a lump sum and then repay the loan through fixed payments at a fixed rate of interest. HELOCs have variable interest rates with non-fixed payments.
Since you are using your home as collateral for the loan, the interest rates on home loans are typically lower than other types of financing, especially credit cards. However, if you fail to make fixed monthly payments on time, it could lead the lender to mortgage your home and eventually foreclosure.
Can I Use a Home Loan for Debt Consolidation?
Home loan borrowers can withdraw a lump sum and use as they see fit. Home loan can be a great way to get cash upfront to settle high-interest bills in one fixed payment.
The interest rates on home loans are typically lower than many high-interest loans such as credit cards. If you want to save on the interest rate differential, a home loan can be a great option to consolidate and pay off debt.
A home loan can be a great option to help consolidate your debt. However, since your home is at stake, you should only take out this type of loan if you are certain that you will be able to make the payments.
The caveat is that you need to make sure that you can make the loan payments. Late payments can mean that you lose your precious collateral – your home. It’s important to make these payments on time to avoid worsening or a debt spiral, Ortoli says. “A home equity loan should only be used for debt consolidation if you have a steady source of income and you are certain that you can make all of the payments on the new loan,” Ortoli says.
Weighing the pros and cons of a home loan for debt consolidation
- The interest rates are usually lower than other loans.
- It can be easier to qualify for “since it’s a secured debt,” says Ortoli.
- Able to buy from various financial institutions on the best terms and lowest interest rates.
- The funds are received in a lump sum so that borrowers can settle large debts and other expenses immediately.
- No guidelines for the use of the borrowed funds.
- The prices are usually fixed.
- Depositing your home as collateral where failure to pay the payments could result in the lender mortgaging your home.
- The readily available credit could mean it is too accessible to the financially unprepared, Ortoli says.
- When home value falls, home loan borrowers can end up in more debt than their homes are worth, leaving them in a deeper hole.
- This is a loan in addition to an existing mortgage.
Alternative ways to consolidate debt
“Ultimately, consolidation is an effective strategy, but see it as a treatment, not a cure,” says Klingelhoeffer. “The real cure is to have positive cash flow and to keep your debt down to a manageable level.” The release of monthly cash could also allow funds to flow into an emergency fund and into retirement. Many experts will say that it is important to start early as a positive step in wealth creation.
If you don’t want to risk a lien on your home but want to free up cash flow and consolidate debt, there are several alternative debt consolidation options.
Credit transfer credit card: Some credit transfer cards offer an introductory interest rate of 0%. Most are between 12 and 18 months before the APR comes into effect. Multiple debts can be transferred to the card. If you settle the card balance before the end of the introductory period, 100% of all your payments will flow on the balance in lieu of the balance plus interest. This strategy can help pay off debt faster and save on overall interest. However, depending on the issuer, there may be restrictions on the type of debt that can be transferred if a home loan does not have a usage policy.
Private loan: A personal loan may be a better or worse option depending on the APR for which you qualify. When the personal loan is unsecured, there is no need to use your home as collateral. And if you can secure a personal loan rate that is lower than a home equity rate, it could work in your favor. Typically, you can use funds from personal loans as you see fit. However, be aware of the origination fees and the early withdrawal fees.
Debt Management Plan: If you have unmanageable debt and need help sorting your options, a credible credit counseling agency can help. We recommend using an agency qualified by the National Foundation for Credit Counseling.
Debt settlement plan: Using a debt settlement service can help negotiate your debt. However, the service is not free. Ultimately, you don’t have to pay anything for this service as you can get in direct contact with the creditors and negotiate or settle the claims yourself.
Refinancing: Interest rates are currently low. So if you own your own home, you can benefit from new, favorable loan terms. Refinancing a 30 year mortgage can allow you to spread the loan balance out over 30 years versus 10 years like a home equity loan, says Chuck Czajka, founder of Florida financial consultancy Macro Money Concepts. If a refinance lowers your monthly mortgage payment, you can use the cash flow that is freed up to pay off your debt.
A cash out refinance could also work by taking out a new mortgage that is greater than what you owe but receiving a check for the difference that you can use as you wish upon completion. It is conceivable to refinance the entire mortgage and raise the necessary equity to repay debt, says Czajka. Pay close attention to the closing costs. The closing costs can outweigh the cost of your debt.
How to Obtain a Debt Consolidation Home Loan
If you decide that a home equity loan is the best option for you, here’s what to do with it.
- First of all, it is important to know how much your home is worth so that you know how much equity you have.
- Check your credit score and take steps to increase it so that you can get a cheaper rate.
- “You can get a debt consolidation home equity loan by first filing an application with the bank holding your mortgage,” said Czajka. “This bank will likely know you and help you get through the home loan process faster.”
- Before you apply, buy and compare the best rates, terms, and fees with at least three lenders.