How Does a Home Equity Loan Work and How to Use it to Consolidate Debt
How Does a Home Equity Loan Work?
If you’re looking for a way to deal with debt that is both flexible and affordable, home equity loan may be a good solution. For homeowners who have built up some equity in their homes, this type of loan allows them to tap into that equity and use it to pay down high-interest debt. Here’s a closer look at how home equity loans work, and when they work well for debt consolidation.
A home equity loan is a loan that uses the equity in your home as collateral. The interest rate on these loans, because they are backed by the value of the home, is much lower than most other types of consumer debt.
Using home equity loans for debt consolidation is common practice. You will apply for the loan from your lender like you would any other type of personal loan, using the home’s equity as the collateral. The lender will request a home appraisal to ensure that the home has enough equity to back the amount you’re asking for. You also may need to pay closing costs, like you do when you get a mortgage, but those will vary from one lender to the next. When you receive the check for the home equity loan, you will then use that money to pay off your high-interest credit cards and other types of debt. As long as you avoid adding more debt to the equation and pay off the home equity loan as agreed, this can help you get out of debt more quickly and more affordably.
Home Equity Loans vs. Home Equity Lines of Credit
Using the equity in your home to pay down debt can be done in one of two ways. A home equity loan gives you a set amount that you receive in one lump sum at closing. A home equity line of credit, or HELOC as they are sometimes called, gives you a credit line you can tap whenever you need some funds, similar to the way you use a credit card but with a much lower interest rate.
Home equity lines of credit have some drawbacks over home equity loans. First, they sometimes have adjustable interest rates. This means that the interest rate can change as long as you have the credit line. If the interest rate goes up, your monthly payment amount and the amount you end up paying over the life of the credit line will also go up.
Home equity lines of credit allow you to draw money as you need it. When consolidating debt, this may not be as helpful as one lump sum payment. It can also tempt you to overspend, because the line of credit can feel like free money.
However, home equity lines of credit can help keep you from adding to your high-interest debt. If you face an unexpected expense after opening the line of credit, you will have a resource to tap to pay it, rather than having to pull out the credit cards again. As long as you are disciplined not to use the line of credit for non-essential purchases, this can be a benefit.
Home equity lines of credit do have one other benefit over home equity loans. With a line of credit, you only pay interest on the amount you choose to take out. If that amount is smaller than originally anticipated when you started shopping for a loan, you will pay less interest than you would if you took out an unnecessarily large home equity loan.
While both HELOCs and home equity loans can be used in debt consolidation, in general, a home equity loan makes more sense than a home equity line of credit. It forces the discipline of not over-spending, has a fixed interest rate, and gives you a lump sum to pay off the debt instantly.
How Much Home Equity Do You Need to Consolidate Debt?
If you think that home equity loans are a good option for your debt concerns, you may be wondering how much home equity you need to make this plan work. This answer may depend on the lender, but you need to be careful not to borrow the full value of the home. Some lenders will cap mortgage and home equity loans to 80 to 90 percent of the home's value, so typically you need at least 20 percent equity to consolidate debt into your home through a home equity loan.
This is an important protection for both you and the lender. Home prices are constantly changing, and sometimes they do drop. If your home's full value is wrapped up in your primary mortgage and a home equity loan, you could end up upside down if values drop.
Home Equity Loan Mistakes to Avoid
Home equity loans are often a good way to consolidate debt, but there are potential mistakes you could make that would make your loan more costly. As you plan for your debt consolidation, take care to avoid these home equity loan mistakes:
- Not realizing the stakes — A home equity loan puts your home on the line. Yes, it is a more affordable loan option, but if you run into hard times, you could lose the roof over your head. Make sure you understand the stakes before signing up for one.
- Not shopping around — Interest rates, accessibility, and closing costs can vary significantly from one lender to the next. When shopping for home equity loans, make sure you do your homework and get more than one quote.
- Borrowing too much — If possible, keep your home equity loan and mortgage amounts to 80 percent of the home's value or less.
- Failing to read all the details — Before signing the closing documents on your home equity loan, read the terms and make sure you understand them. Make note of extra fees, like closing costs and the appraisal fee. Check for any prepayment penalty.
- Not checking the credit history — Finally, don’t apply for a home equity loan before checking your credit history. If there are errors on the credit report, have them adjusted before you take out the loan. You may get a lower interest rate as a result.
Understanding Closing Costs
Like all mortgages, a home equity loan has closing costs. These will vary from one lender to the next, but they typically fall between 2-5% of the loan. Closing costs cover the lender’s expenses for creating the loan, such as:
- Appraisal fees
- Origination fees
- Title search
- Credit report fee
- Document prep fees
If necessary, these can be rolled into the loan to protect you from a large upfront payment.
Ask About Pre-Payment Penalties
Finally, when shopping for a home equity loan, make sure you ask about pre-payment penalties. These are fees that the lender charges if you pay off the loan early. Avoid loans with prepayment penalties, if possible, but make sure you understand what they are. Should you have the ability to get out of debt sooner, you want to have the freedom to take advantage of that!
How does a home equity loan work? It allows you to tap your home's value to pay expenses, including high-interest debts. If you find yourself struggling with large amounts of high-interest debt, and you are sitting in a home with a lot of equity, you have the potential to consolidate that debt, lower your monthly payments, and get out of debt more quickly. Do your homework first, but be willing to consider a home equity loan as an option to deal with your debt more affordably.