You are in over your head in debt. What are you supposed to do? You don’t have enough savings to get you out of debt. But, you do have equity in your home. Whether you made a large down payment or you paid the loan down a little at a time, the equity is yours to use. It is an option to help you get rid of the debts you have. Here we discuss how it works and help you decide if it’s the right choice.
How do you Reduce Debt With Your Home Equity?
Reducing debt with a home equity refinance works in one of 3 ways:
- A cash-out refinance where you refinance your 1st mortgage and cash in your equity
- A home equity line of credit which is a 2nd mortgage that works like a credit card
- A home equity loan which is a 2nd mortgage that works like the 1st but has 2nd lien position
These 3 different ways have one thing in common – they tap into your home’s equity. They are all a lien on your home. They all also use your home as collateral. If you don’t make your payments, you could lose your home.
No matter which option you choose, you apply for the mortgage as you did your first mortgage. You must disclose your income, assets, and liabilities. You’ll also have to pay for an appraisal. This is how the lender knows how much they can lend you. A home equity refinance often allows LTVs between 80-100% depending on the loan program. Conventional cash-out loans allow up to 80% LTV. VA cash-out loans allow up to 100% of the home’s value. Home equity loans usually allow up to 85% depending on the lender.
Any loan you choose will work the same way. Once approved, you head to the closing. At the closing the closing agent pays off your existing first mortgage, if you took a cash-out refinance. If you took out a home equity loan, the closing agent doesn’t have to pay off any mortgages. With either type, though, the closer will pay off the debts you are rolling into the loan. For example, if your proceeds are paying off credit cards, the closer will pay them off for you. In some cases this step is optional, but only if your debt ratio supports both the new mortgage payment and the existing debt.
The Benefits of Paying off Debt with a Home Equity Refinance
Using a home equity refinance to pay off debt can help you eliminate debt. That’s an obvious benefit. There are others, though.
- Smaller interest rate – The difference between a mortgage interest rate and a credit card interest rate can be as much as 10-15%. When you calculate that out over a period of a few years, it really adds up. Even if you only have a little debt, interest can keep compounding until you pay it off.
- Tax deductions – You may be eligible to write off the interest you pay on your taxes. How much you can write off depends on your situation. Always discuss this with your tax advisor first. For example, if you took out a HELOC, you may only be able to write off the interest on the first $100,000.
- Easier payments – If you had large amounts of debt, it’s easy to get confused. Making one late payment can spiral downward, causing you many issues. Rolling everything into one payment can make it easier to stay on top of your payments. This way you can get out of debt faster.
The Downsides of Paying off Debt With Home Equity
Of course, with the good always comes the bad. Paying off debt with your home equity has some issues that you should understand.
- Paying the debt for a longer period – Rolling credit card debt into your mortgage means you’ll carry the debt for the term of the loan. This could mean as much as 30 years. If you figure out the interest you’ll pay on that debt, it could be enormous.
- Putting your home at risk – Rolling unsecured debt, like a credit card, into your mortgage puts your home at risk. If you become unable to make your payments, you could lose your home. If you stopped paying your credit card payments, though, you wouldn’t lose your assets. You might have a judgment against you, but that’s about the worst of it.
- Closing costs – Every mortgage loan costs money to close. Lenders charge different fees based on the work they have to do. Some lenders may also charge you points to get a certain interest rate. When it’s all said and done, you could pay as much as 5% of the loan amount in fees.
What to Watch Out For
If you decide to consolidate your debt with a home equity loan, watch out for the debt cycle. We don’t recommend closing your credit cards that you paid off. This could harm your credit score. The older your accounts are, the higher your credit score stays. Closing too many cards at once can lower the average age of your accounts. This leaves you with a lower credit score.
But, if you keep the cards open and they have an available balance you could get right back into debt. Instead, lock the cards up and put them away. Only use them if you have a dire emergency. Otherwise, let them be. Work on paying your mortgage down so you see the largest benefit of the refinance.
The Final Word
Eliminating debt is always a good idea. Even if you have to tap into your home’s equity, you are out of debt. If you stay consistent with your home equity payments, you can own your home and be out of debt. It’s the first step in getting your finances organized. The next step is making larger payments so you can knock the principal down faster and own your home free and clear.