Using Home Equity to Consolidate Debt
When embarking on the initial stages of eliminating consumer debt, many people feel overwhelmed with the volume of individual debts to different creditors. One common desire is to try and consolidate all of your debt into one payment that feels easier to manage. With that thought in mind, there are numerous so-called experts that make the recommendation to consolidate consumer debt with a Home Equity Loan (HEL) or Home Equity Line of Credit (HELOC).
In the current real estate market, many homeowners have benefited by a considerable increase in their home equity and are tempted to take advantage of that increased value. Even though this is recommended by many people in the financial industry, there are numerous reasons why using a HEL/HELOC to consolidate debt may not be the best option for some people. If this is something that you are considering, please do your homework and review the potential pitfalls to determine if this is the right path for your debt elimination strategy.
At this point, you may be asking why the use of Home Equity Loan or Home Equity Line of Credit would be a bad idea. Consider the following potential drawbacks:
- Unsecured Debt versus Secured Debt.
- Credit card debt is unsecured debt, which means that there are no underlying assets that the creditor can come after if you fail to pay your bill. A Home Equity Loan or Home Equity Line of Credit is secured debt, with your home being the asset used as collateral. So what does this really mean? Well, if you have transferred your unsecured credit card debt to a HEL or HELOC secured by your home, you are now at risk of losing your home if you should ever run into difficulty repaying your loan.
- If you should have problems paying your loan, the lender can force you to sell your home. Given that you may be required to sell your home at a less than opportune time, there is a possibility that you may not be able to sell the home for more than you owe on your mortgage and HEL/HELOC.
- Variable Interest Rates.
- A Home Equity Line of Credit has a variable interest rate. What exactly does this mean? Basically, it means that you will never have a fixed monthly payment and there is the possibility that your payments can rise over time. In most cases, people consolidate with a HELOC because they are having a difficult time managing their existing debt. How will you be able to handle an increase to your monthly payment? Will you be able to incorporate the increase into your budget? Think about the consequences of not being able to afford your HELOC payments. If you need a reminder, take a step back and review the section on unsecured debt versus secured debt above.
- Often times people have found themselves mired in credit card debt due to poor money management practices and living above their means. When consolidating all of your credit card debt into a HEL/HELOC, there are now numerous credit cards that no longer have a balance. The risk here is that unless you have addressed the money management issues, there is a very high likelihood that you will be tempted to continue spending on the credit cards. It will not take long before the credit cards all have a considerable balance again, however now you no longer have any home equity either because you had already used that on the original credit card debt.
- Another source of temptation can arise with the use of a HELOC. Often times people receive a HELOC that is larger than the sum of the debts being consolidated. As such, there is the possibility to access additional funds that may be too easy to resist and you will find yourself with a larger debt than you had before consolidating.
- Duration of Repayment.
- When consolidating debt with a HEL or HELOC, one will typically have a lower monthly payment. While this can be an advantage if you are currently strapped for cash, it is important to realize that the total amount being paid is likely to be much larger because you are paying the debt over a longer period of time.
While the list above references some of the potential risks with the use of a Home Equity Loan or Home Equity Line of Credit, that does not mean they are a bad option for everyone. Just as there are risks, there are also some potential benefits:
- Lower Interest Rate.
- Even though the interest rate on a HELOC is variable, as they often are with credit cards as well, the interest rates for a HEL/HELOC are typically lower than credit cards. Depending on your credit history, it is not uncommon to have an interest rate of 20% or more on your credit cards. With proper money management skills, the use of a HEL/HELOC can offer significant savings just as a result of the lower interest rate.
- Interest may be Tax Deductible.
- Depending on your circumstances, it is possible that the interest on a Home Equity Loan may be tax deductible on your income tax returns. This potential benefit stresses the importance of doing your homework, as you should determine whether or not you will be able to take advantage of this benefit given your current situation.
As you can see, there are potential drawbacks as well as potential benefits to using a Home Equity Loan or Home Equity Line of Credit to consolidate debt. It is critical that you perform an honest evaluation of your own circumstances, as well as your money management skills, to determine if this is the right option for you.
Unfortunately, it is far too common for one to consolidate debt with a HEL or HELOC only to find themselves back in credit card debt as time passes. This can really be a disaster as now you still have the original credit card debt that is secured by your home and a new pile of credit card debt. Be honest with yourself and answer this question, can you resist the temptation and potential drawbacks of using a Home Equity Loan or Home Equity Line of Credit to consolidate your debt?