Using a home equity loan to pay off debt

If you own your home and have been building equity in it, you may have an option that could simplify and potentially reduce the cost of your existing debts.

A home equity loan is a one-time loan against your home. The interest rate is typically fixed—and lower than the rates on most credit cards or personal loans. You may be able to use this type of loan to consolidate higher-interest debt into a single, more manageable monthly payment. 

How a home equity loan works for debt consolidation

A home equity loan is a mortgage. If you’re still paying down the mortgage you got when you bought your home, the home equity loan will be a second mortgage. You borrow a specific amount, receive it as a lump sum, and repay it over a set term, often five to 30 years. Because your home secures the loan, lenders typically offer lower rates than they would on an unsecured personal loan or credit card.

To find out if you qualify, lenders generally look at your credit score, debt-to-income ratio, and how much home equity you have. 

How much can you borrow?

The amount you can borrow with a home equity loan varies according to your home's current value, your remaining mortgage balance, and the lender’s home equity loan limits. 

Your lender takes your combined loan to value, or CLTV, ratio into account when determining how much you can borrow. CLTV is calculated by adding all of your outstanding home loan balances and dividing that number by the current market value of your home.

For example, if your home is worth $400,000 and you owe $250,000 on your primary mortgage, you have $150,000 in equity. A lender allowing up to an 80% CLTV on a $400,000 home would cap total borrowing at $320,000. So after taking into account the $250,000 you already owe on the mortgage, the lender might offer up to $70,000 with a home equity loan. 

Potential benefits of using a home equity loan to pay off debt

Using a home equity loan for debt consolidation has some advantages:

• A lower interest rate. Home equity loan rates are typically well below credit card APRs. They may also be lower than rates for a personal loan since your home guarantees the loan, which reduces risk for lenders. 

• One monthly payment. When you use a home equity loan for debt consolidation, you combine multiple debts into a single monthly payment. That could simplify your finances, and lower the chance you’ll miss a payment due date.

• Predictable payoff timeline. Unlike credit card minimum payments that can stretch debt out for years, a home equity loan has a fixed term with a defined end date. 

Drawbacks to consider 

Using a home equity loan to pay off debt has some drawbacks worth thinking through carefully:

• Your home becomes collateral. If you can’t repay your home equity loan, you could lose your home. 

• Closing costs usually apply. Home equity loans typically come with closing costs of 2% to 5% of the loan amount. On a $50,000 loan, that’s $1,000 to $2,500 upfront, depending on the lender.

• Debt consolidation doesn't address the causes of debt. Examine the reason you’re in debt. If you’re still working on money management skills, create a plan before you get the new loan. If you get a home equity loan and then run up new balances on your credit cards, you could end up in a worse financial situation. 

When a home equity loan may make sense for debt consolidation

Using a home equity loan to pay off debt could make the most sense when:

• You have sufficient equity in your home.

• You have a stable income and a realistic plan to repay the loan.

• Your debt carries high interest rates relative to what you'd pay on a home equity loan.

• Your total debt is manageable relative to your income.

When a home equity loan may not be the right move

Using a home equity loan to pay off debt may not be a good idea if:

• Your income or employment is unstable.

• Your debt load is large relative to your income, which may suggest that debt relief is worth exploring instead.

• You've consolidated debt before, but it didn’t break the cycle of accumulating debt.

• You're close to retirement and prefer not to take on new secured debt.

Alternatives to consider

A home equity loan isn't the only option for consolidating and paying off debt. Other options may carry less risk or be a better fit for your situation.

Personal loan

A personal loan for debt consolidation doesn't use your home as collateral. Rates are typically higher than home equity loan rates. If you don’t want to borrow against your home but want predictable monthly payments, consider looking into a personal loan.

Balance transfer credit card

With a balance transfer credit card, you can move multiple credit card balances onto a single card. These cards often come with a low or 0% introductory rate for a short time (often 12 to 18 months). 

If you have good credit and think you can pay off your debt relatively quickly, this could be a good option. But if you need more time, a balance transfer could be costly. Any balance you don't pay off by the end of your introductory period becomes subject to the card's standard APR, which is often a much higher rate than a home equity loan rate.

Balance transfers can turn into a juggling act. You might repeatedly try to move unpaid balances to a new balance transfer card and start running out of offers. Or you might end up with multiple balances that you didn’t have before. It’s a good idea to consider a balance transfer a one-time strategy that’s part of a clear plan to put your debt behind you.

Debt relief

If your debt is overwhelming, debt consolidation might not be the right path. If you genuinely can’t afford to fully repay your debts and you don't know how you’ll deal with them, you may want to consider a debt relief program. With a debt relief program, you may be able to settle your debt for a lower amount than what you owe. 

How to decide

Before deciding to use a home equity loan to pay off debt, there are some key questions to ask yourself:

• How stable is my income now, and is it likely to remain stable? 

• Can I keep up with home equity loan payments?

• Am I comfortable borrowing against my home?

• Have I compared the total cost of a home equity loan, including closing costs, to other options?

Achieve offers home equity loans as well as debt relief programs. Talk to a debt expert to explore different paths before making a decision.