Good NestingWith rising interest rates, such payments can put a family in financial hardship. However, homeowners who have available equity on their properties can avoid this by consolidating their non-mortgage debt with a home equity loan.
Home equity loans have much lower interest rates and generous repayment terms than credit cards, medical bills and car loans. Homeowners can take advantage of these loans to save money on interest and simplify their monthly bills. However, there are some things to consider before asking for a home equity loan or line of credit.
What is a home equity loan?
A home equity loan is a financial product used by homeowners to get funding using their home’s equity as collateral. These loans are also known as second mortgages, although that name is mostly used when a lien is already placed on the property used as collateral. Home equity loans can be provided as a one lump-sum of money or line of credit.
Home equity loans given as a single lump-sum of money work like any other loan. Once customers get approved, lenders deposit the money in a designated bank account for borrowers to use. Most home equity loans have no limits on how the money can be used. However, borrowers may receive lower interest rates and more generous repayment terms if the money is used to perform home repairs or improvement.
Borrowers can also request the money be provided as a line of credit instead. In those cases, they receive a home equity line of credit, or HELOC, which can be used and re-paid multiple times. HELOCs are very useful to families who are looking for a safeguard against emergencies instead of money to cover an immediate expense.
Benefits of home equity loans
Home equity loans and lines of credit have many benefits, especially when it comes to consolidating debt. In general, banks consider credit history, debt-to-income ratio, and other financial data to determine how much money they can lend customers. This is often not the case for home equity loans. In most cases, homeowners have access to as much as 80 percent of their home’s equity as loan amount. This is because unlike credit cards and unsecured loans, home equity loans are guaranteed by an existing asset.
There are some specific benefits that home equity loans offer someone trying to consolidate debt. First, borrowers who consolidate debt with a home equity loan will only have to worry about one monthly payment. This can help families better organize their finances when compared to handling different due dates for medical bills, credit card debt and car loans.
The second benefit of home equity loans is that they help borrowers know when their debt will be paid off. Most families pay off credit card debt while they continue using them frequently. This makes figuring out a payoff date complicated, as new debt often extends payment periods. A home equity loan comes with a certain number of monthly payments, which remain unchanged unless borrowers refinance their loan.
For example, a consumer owes $10,000 in credit card debt and decides to pay down $3,000 each year, in monthly payments of $250. The interest rate on their credit card is 18 percent. After twelve months, consumers would still owe $8,800 due to interest. If consumers spend an additional $1,000 during the year, their balance would be around $9,900. Without new spending, it would take consumers 62 months to pay off their debt.
The third benefit of home equity loans is their much lower interest rates. Using the example above, it would take a homeowner 36 months to pay off a $10,000 home equity loan with a 5 percent interest rate and monthly payments of $300. Total interest paid on the loan would be around $800, which is much lower than the $5,400 paid on interest had they kept the balance on their credit card. By consolidating their debt with a home equity loan, the consumer saved $4,600.
Most home equity lines of credit come with adjustable interest rates. This means that the total amount of money saved in comparison to credit card debt will vary. However, HELOCs still have much lower interest rates that credit cards, and unlike home equity loans, can be reused even after being paid off. Also, customers who are still paying off their mortgages can request borrowing limit increases on their HELOC as they make monthly payments.
Consolidating debt using home equity
The first step to consolidate is calculating how much money will be required to cover debt payments. For example, a family that owes $10,000 in credit card debt, $5,000 in medical bills, and $13,000 on a car loan would require a $28,000 home equity loan or line of credit. Families who have a precise spending plan may prefer a home equity loan due to lower interest rates. However, applying for a line of credit might be beneficial if they expect new spending in the near future.
Once families know how much money is needed, the second step is to determine available equity. As explained above, most lenders provide up to 80 percent of a home’s equity as loan amount. This number includes other liens on the property, such as other mortgages. For example, if a family owns a $200,000 house and still owes $100,000 on their first mortgage, the maximum amount available to borrow will be $60,000.
In some cases, appraising the property will be needed to see if its current market value matches the original sale price. The appraisal process is often performed by real estate professionals, who take into consideration new additions such as a pool or fence. However, if the house has remained largely in a similar state, borrowers might bypass the appraisal process to save money. Most real estate professionals can charge between $300 and $500 to perform an appraisal. This is a significant expense that reduces the amount of money saved by consolidating debt.
Once the market value has been determined, homeowners can contact several lenders to compare interest rates, closing costs and other fees. Families with good credit histories are often approved the maximum loan amount without much trouble. However, interest rates and closing costs are usually similar for families with weaker financial histories. In general, interest rates for a home equity loan or second mortgage varies between 3 and 8 percent.
Some financial institutions offer borrowers a promotional interest rate for the first twelve to thirty-six monthly payments. For example, State Farm Bank offers home equity lines of credit with a promotional interest rate of 2.9 percent. After twelve months, the rate changes to 6.85 percent. Watertown Savings Bank, in contrast, offers a promotional rate of 4.2 percent for 36 months before increasing it to 6 percent.
Another important factor to consider when comparing HELOCs is the minimum initial draw amount. Bank of America, for example, requires borrowers to draw at least $50,000. If a family only needs $28,000, such an amount would not make sense. In general, borrowers are required to draw between $10,000 and $15,000 to get approved for a HELOC, although small banks and credit unions have no such limits.
Once a lender and amount have been chosen, the final step is submitting an application. During the process, lenders will ask for relevant documentation and verify whether homeowners meet their financial standards. In general, lenders approve loan applications from customers with a credit score at or above 620, debt-to-income ratio below 43 percent, and history of paying bills on time. Some lenders accept debt-to-income ratios as high as 50 percent, though with higher interest rates.
Things to consider when consolidating debt with home equity
Homeowners must consider several factors when calculating how much money they would save by consolidating debt. The process of requesting a home equity loan or line of credit can become complicated and time-consuming. Several steps, such as appraisal, can take weeks or even months. This means that families who need the money right away might be better off applying for a personal loan.
Another important factor to consider is risk. Home equity loans and lines of credit are secured loans which use a property as collateral. Homeowners who are unprepared to make their monthly payments on time may face foreclosure and lose their homes. Families should only apply for a home equity loan if they are able to cover monthly payments. In most cases, it is less risky to default or skip payments on unsecured debt, as doing so does not pose an immediate risk to families.
Home equity loans and lines of credit often have expensive closing costs attached to them. Before applying for one, homeowners should calculate how much would it cost to get approved. Otherwise, they may end up not saving as much money as possible, or spending more money in the long term.
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