You might have bought your house using a loan and would have been paying a mortgage for the past 20 years. The house now would have grown a lot in value. You might have sudden needs for a large amount of money, you might even need to pay off a loan. While you could search around for a source of money, you can actually get a loan on your mortgaged house. This type of loan has a much lower interest than other kinds of loans, so you could use the money you get from the equity loan to pay off any high-interest debts. However, you must be careful, while the interest rates are lucrative, it does come with risk. You could take a major financial hit if your house’s value plunges, the economy crashes, or you if you become unemployed.
Pros of using equity loans for debt consolidation
- The interest rates on home equity loans are typically lower than the interest rates of credit card debts. This is because credit cards do not include collateral, thus the lenders will have a tough time getting their money back if you stop paying, they usually end up selling the debt to some collection agency. An equity loan, on the other hand, is backed up with collateral. This increases the chances of the lender receives his money back.
- You will no longer have to pay monthly installments for multiple debt sources. The longer repayment period of equity loans also means smaller monthly payments, so you will be able to have a little extra cash every month.
- You could get a tax deduction if you use the equity loan to build, restore, or improve the house that you have taken the loan against.
Cons of using equity loans for debt consolidation
- The chances of you being able to discharge a home equity loan are very slim. You have to pay the money, or your house will go into foreclosure. Credit card debts, on the other hand, are dischargeable. So, if you are not able to properly manage your debt, you will risk losing your house.
- If your home loses its value, it will lead to a severe financial crisis. When home value plunges, you will end paying more money than what your house is actually worth. The trends of real estate vary from market to market, so it is hard to predict if the real estate economy will crash or not. If the market does crash and you end up owing more money than what your house is worth, and a recovery in the market seems nowhere near, you might be tempted to forfeit your house. This will significantly harm your ability to take loans for years to come.
- If you take more loans than you require to pay your debts and end up spending the excess money on consumer items after you paid your consumer debt, you will end up owing more money than you did before you used equity loan to consolidate your debt.
Qualifying for equity loans for debt consolidation
Lending companies won’t give you an equity loan unless you meet a few requirements. Even though you hold equity on your hose, lenders do not want to go through the hassle of foreclosure to get their money back. Thus they will consider several factors, including your income, investments, other debts, credit score, and the ratio between the loan and the value of your house. The loan-to-debt ratio is the amount of money you have borrowed compared to the value of the house. If your house is worth $500,000, and you borrow $200,000, the loan-to-debt ratio is 40%.
Lenders prefer home equity loans over other kinds of loans, this is as the borrowers have a significant amount of money tied up with their huge i.e. the collateral. Thus they are less likely to default and risk losing their house. This is why foreclosure rates have always been low.
You cannot borrow more money than the value of your equity in your house, in most cases, you will not even be able to borrow that much. Most lenders place a 20% equity cushion, this is the difference between the value of your house and the combined value of your primary and secondary mortgage. For example, if your house is worth $500,000, you will have to leave $100,000 of your equity untouched. If you already have a mortgage of $200,000, you only be able to take an equity loan up to $200,000.
What are the types of debts that can be consolidated using equity loans?
The lending company will typically want to know what you are going to spend the loan on. While you could use it for credit card debt consolidation, you can also rework on your house using the money. That said, there are no real restrictions on what you spend the loan on. While it is financially sensible to use equity loans to consolidate your car and credit card debts, it is up to you to decide. The lender only wants you to make monthly payments in accordance with the terms of credit.
Consolidating all your debt on your house has many benefits. You will have to pay lower interest rates and smaller monthly payments. This is very useful to get rid of the high-interest rates of consumer debts like credit card debts and car debts. However, there is always a risk that you will lose your house if you fail to make monthly payments. Thus, you must only use equity loans to consolidate debt when you are sure that you will not be in a position to default on your payments.