When you check your monthly bank statements and observe that a great amount of money is going towards debt payment, how does it feel? Aren’t your finances in a grave danger?
If so, then what are you doing to save that money?
Most of the time the answer will be…Nothing!!
Then what should you do? You need to arrange funds and pay off the debts once and for all.
The next question that should come to your mind is “What is the best way to gather such huge funds?”
Many of the industry professionals would say – “by using your home equity, you can take out a home equity loan to consolidate debts. Similarly you can use a home equity line of credit (HELOC)” for the same purpose. The interest rate of a home equity loan is tax deductible and lower than any other conventional loans. So, it would be a good choice.
But which one to select? Not sure? Then, let’s have a detailed discussion about choosing a home equity loan or a HELOC to consolidate your debts so that you can be sure whether it is a suitable option for you.
To understand the discussion first, we will discuss:
(a) What is a home equity loan?
In case of a home equity loan, you are able to borrow money against your home equity (the current value of your house).
Your home equity will be calculated as = (Your appraised home value – The value you owe on a mortgage).
For example, if your home’s appraised value is $250,000 and you owe $150,000 on the mortgage, your home equity will be $100,000. So, you can use that $100,000 equity to get a home equity loan.
Home equity loan is also called second mortgage as you’re tapping your home equity to take out another mortgage and pay it off through monthly installments.
Most of the time, your existing mortgage lender will be very much interested to approve a home equity loan. It is because the lender is getting the chance of making money on a house twice, as a first mortgage and a second mortgage with a slightly high-interest rate. In both the cases, the collateral (the house) remains the same.
(b) What is a home equity line of credit?
A home equity line of credit (HELOC) can be used as a credit card. You’ll be approved for a line of credit for a certain draw period (normally up to 10 years).
There are 2 types of HELOC – a) an interest-only draw period, and b) a draw period with interest and principal. Both are optional; you can choose as per your financial situation.
For the first option, you just need to pay the interest on the money you are drawing.
On the other hand, you can pay both the principal and interest in the second option. By this way you can pay off the debt sooner.
When the draw period expires, you can’t use the credit line anymore. Your repayment period will start immediately when the draw period expires. You have up to 20 years to repay the loan. The lender may renew the credit line. You need to get his approval before the draw period ends.
(c) Is there any difference between a home equity loan and a HELOC?
Home equity loan and Home equity line of credit (HELOC), both are two totally different types of loans.
a. Home equity loan
You can take out a handsome amount as a loan by using your home equity as a collateral and repay on a monthly basis. Suppose you have taken out $100,000 home equity loan, with a fixed interest rate, you need to pay it off within a fixed repayment period.
b. Home equity line of credit
It will also require collateral. You’ll get a credit line and use that credit as per your need. It’s not a fixed amount loan, so you only need to pay interest on the part of credit you are using.
For example, if you have a $20,000 HELOC approved on your home equity and used only $5,000 credit to repair your garage, you need to pay interest for the $5,000 only. You have $15,000 credit left to use. In HELOC, you can also repay the amount and get the credit line live to use it as a revolving credit.
(d) Can you consolidate all types of debt with home equity loan and HELOC?
This is one of the important questions that people may ask somehow. As a matter of fact, people can use these loans to pay off any kind of debt they want to. Using home equity loan or HELOC, they can get rid of credit card debts, payday loans, car loans, and many more. In the end, there will be only one loan. So, it is easier to manage only one loan payment rather than multiple loans every month.
You can take out these loans and use the money to pay off your secured and unsecured debts. If the loan amount if greater than your debts, you can use the extra funds to finance other requirements. You can support your family members, you can start a small business, you can repair your home, you can pay for your guitar lessons, you can pay for a family vacation… and many more.
However, you need to understand that it is really an expensive option to finance a vacation. So, it is suggested that you should invest the money in a project where you can generate revenue.
Getting out of debt is a fascinating thing. But most of us don’t know the best way to do so. If you have a stable income, start saving now. If you spend too much towards luxury, cut them off right now. Consolidating your debt is not an easy job to perform. Calculate your total monthly payments first so that you have a clear idea what amount you have to pay, and how much you need to save for paying off the second mortgage later.
It is clear to us that you can take out a home equity loan or a HELOC to consolidate debts of any kind. But you should always think about the risk factors before using the home equity for the second time.
(e) Is it a good idea to use your home equity to consolidate debt?
You may take out a home equity loan to consolidate debts, so that your interest rate can be lower. But there are always few a risks which you need to consider.
Some experts may suggest you to use the home equity in emergency cases rather than for making debt payments.
Let’s check out how much this statement makes sense:
Pros and cons of using home equity loan or HELOC to consolidate debts
- Home equity loans and HELOCs have lower interest rates than a debt consolidation loan or other credit lines like credit cards or payday loans.
- Monthly payment is lower than other loans, so it won’t hurt your budget.
- The interest is typically tax deductible.
- The house will be used as a collateral. If you fail to pay off the loan, the house might be foreclosed by the lender.
- Home equity loans have closing costs and other fees.
- There are chances of dropping home value, you may owe more than what you borrowed.
- Repayment tenure is longer, normally 10 years or more.
If you have a good credit score, you can have other options to consolidate your debts like a personal loan, a debt management program, or 0% balance transfer card (in case of credit card debt), or the last option – bankruptcy. A Chapter 7 bankruptcy will remove your small debts quickly. After that you’ll get enough time to build your credit score again.
So, avoid risking your home equity just for the sake of debt pay off. If you are not confident enough to manage your finances, you don’t need to transfer your unsecured debts into a more riskier secured debt. It is up to you, so make sure you consult an attorney before making any decision.