Debt Consolidation and Home Equity Loans
If you are drowning in debt, you might want to consider consolidating your debt by refinancing your mortgage into a loan that carries a low-interest rate. If you have enough equity in your home, you can refinance your mortgage using part of your equity to pay off some or all of your high-interest debt. If you have a history of paying your monthly mortgage payment on time, you should have no trouble refinancing into a new mortgage with a very low rate.
Home Equity Loans- The Good and the Bad
As home values continue to recover from the Great Recession of 2008, more homeowners now find themselves with some equity in their homes. In the first quarter of 2014, homeowners tapped into nearly $23.4 billion in home equity through refinance loans and home equity lines of credit, according to U.S. News and World Report. The numbers in the first quarter of 2014 represented a 15.5 percent increase from the first quarter of the previous year. Homeowners often use the money from their home’s equity to pay down high-interest credit cards and other debt. If the interest rate on the new home equity loan is low enough and the homeowner does not face higher monthly mortgage payments, then debt consolidation using a home equity loan is a good choice.
However, if the mortgage meltdown and ensuing recession of 2008 taught homeowners anything, home equity loans can cause serious problems by borrowing more than you can afford. According to a report by CoreLogic, home equity loans and home equity lines-of-credit typically cause borrowers to owe more money than the value of their homes. To avoid this problem, real estate experts recommend that you should not take out a home equity loan for more than 20 percent of the equity in your home. Even if the interest rate is low on a new home equity loan, you are still borrowing against the current value of your home.
Home equity loans can be a smart way to consolidate all of your unsecured debt into one loan with a low-interest rate and low monthly payment. It is a wise tactic if you can avoid incurring new debt. The ease in which people can borrow would defeat the purpose of debt consolidation if you were to pay off your debt today only to incur new debt tomorrow. Remember that your home is collateral for a home equity loan, and if you do not make the payments, you put yourself in danger of losing your home.
The very process of debt consolidation involves amalgamating all debts that a person may have one single monthly payment. This can be done both by non-profit and profit-making debt consolidation companies.
The basic difference between the two is that when consolidation is done by a non-profit debt consolidating company, also called a non-profit credit consolidation company; it will work more for the client’s benefit without prioritizing its own profits or commissions. The profit-making debt consolidation agency, on the other hand, works for its commercial benefit and gain.
When multiple monthly credit card debts along with their respective interest rates become all too overwhelming, the home that you own could come to your rescue and actually help you eliminate debt for good. You could do this by getting a home equity line of credit or home equity loan for consolidating your debts and subsequently paying off all outstanding credit card debts. What’s more, you get tax relief on the interest rate, and it’s also much lower than what you’re paying for your credit cards. In other words, it’s a win-win situation for you all the way.
Home Equity Loan: A Definition
When you borrow against the value of the equity you have in your house, you are said to be taking what is called a home equity loan. The equity amount is the difference between the appraisal value of your home, and what is owed on it by you.
For example, if the appraised value of the house is $250,000 and $100,000 is owed on its mortgage, the equity values is $1,500,000. Your home equity loan will entitle you to borrow against this figure of $1,500,000 and you can repay it in installments every month. This is the reason why it’s also often called a 2nd mortgage.
Lenders are usually eager to give out a home equity loan if you want to consolidate your debts. The lender makes money already on the house’s first mortgage. With a home equity loan, he now gets a moderately higher interest on the 2nd mortgage while getting to keep the same building/house as his collateral.
This ensures the safety of his loan and convinces him of a safe return on his payout. It also needs to be noted that home equity loans and home equity lines of credit are not the same and happen to be two different loan types actually.
The difference between the two can be elaborated as follows: With home equity loans, the debtor receives a lump sum and can subsequently repay it in monthly installments. The abovementioned example shows that you may borrow say, $50,000 and repay in monthly installments with a fixed-interest rate included, over a mutually agreed upon period of time.
A home equity line of credit, on the other hand, is something akin to a credit card. The debtor gets an open-end line of credit and keeps drawing from it as and when required. The singular advantage is that he only pays interest on the portion of the line of credit he uses.
For instance, if a $25,000 home equity line of credit was approved in their favor, based on their home’s equity, and they use $15,000 from that amount to get his or her home repaired, they would only have to pay interest on that $15,000 with the additional $10,000 around to borrow against if the need arises in future. Additionally, home equity lines of credit are also considered what is called revolving credit, which implies that once it’s repaid, you can borrow even more against it.
Qualifying for Home Equity Loans
Qualifying for home equity loans is very easy because the one and only thing required is a home or house with the appropriate equity attached to it. A study conducted in the US last year showed that American homeowners have a whopping $7 trillion in home equity currently, which is enough for each individual owner to draw at least $150,000. But not everyone can do this since most Americans are in debt but this is just one way of looking at things. And because of the Frank real estate crisis, still many Americans have not recovered from that.
Terms and conditions of course, may differ from lender to lender but the approval process is governed by a uniform basic criteria. Borrowers are generally required to maintain 20% of their individual equity after obtaining the loan. For example, if the home’s market value is $300,000, the net amount the borrower could owe would necessarily have to be lower than $240,000. This sum will also include the debtor’s original mortgage as also the home equity line of credit or home equity loan they are wanting to take.
This is needless to say, reduces the lender’s risk because any borrower with an existing investment of a minimum of $60,000 in an immovable asset won’t run from it easily.
Moreover, his chances of renting it out to any third party for use as a commercial or residential property are also remote. This type of collateral allows lenders a certain degree of flexibility when they evaluate borrowers. However, any lender will also minutely check out the borrower’s credit scores while working out the interest rate of the loan.
Any prospective borrower with a credit score below 600 would be considered poor and may not qualify for a home equity line of credit or a home equity loan. That’s why it’s always prudent to consult with a credit counselor if your credit score is poor so that you can repair it before applying for a home equity loan or a home equity line of credit.
When Should You Select a Home Equity Loan?
Before going in for a home equity line of credit or home equity loan, it’s best to weigh your options carefully. You first need to check its financial viability and whether it would really help you advance financially or set you back even further into a deeper hole.
Begin the process by doing the basic math first. This would involve confirming that when you consolidate your multiple debts into one single monthly payment, whether it would turn out to be cheaper than paying them off individually. Also, interest rates are of the greatest importance. For instance, if the debtor owes one year only on an auto loan at 6.5% annual interest, it doesn’t make sense rolling it into a 10-year loan on home equity at say, 5%. So, crunch your numbers first.
A home equity line of credit or home equity loan may provide relief instantly. However, the ready availability of funds can also give you a false sense of monetary gain. As a person who has a habit of reckless spending, therefore, a borrower may be tempted to squander the money on unnecessary luxuries, forgetting that he or she is actually eliminating debt or at least trying to. This could have some serious consequences in the future.
In fact, it has been commonly seen that with the availability of a home equity loan, many borrowers have gone back to their spending habits that got them into debt in the first place. The state of California and Illinois continue to fall into debt but this is another topic. This is called “reloading” by lenders or taking out fresh loans to repay existing loans and using any breathing room to squander more funds. In other words, no loan is worth it if one doesn’t learn to live within his means. And living beyond the funds provided by the home equity line of credit or home equity loan could cost you your dearest asset – your home.
Benefits of Home Equity Lines of Credit & Loans
Lower interest rates than any other financing scheme and ranges between 6% and 36%.
Since the average credit card interest rate is around 16.5% currently, a debtor with a poor credit score pays 5 to 10 points more than that.
A customer with strong credit can get a home equity line of credit at interest rates ranging between 4.5% and 8.15%. Basically, the HELOC or home equity loan rates are 10 to 15 points lesser than what credit card issuers are charging.
Since a home equity loan is taken against a home, the borrower gets a tax deduction on the interest charged. Additionally, they make a single monthly payment compared to multiple payments that they were making to handle all their credit card debts.
Undoubtedly a home equity loan is the cheapest way of debt consolidation because of the substantial savings on high-interest rates. This eases the borrower’s stress levels and they do not need to meet multiple deadlines on numerous bills simultaneously.
On the flip side, however, a major drawback of a home equity loan is that the borrower’s home is being put up as collateral and any failure to make a payment could result in foreclosure or the home landing up in the possession of the creditor. Thus, in the event of a debtor losing their job or the real estate market collapsing, losing his or her home is a very strong possibility.
Moreover, closing costs and fees may also vary from lender to lender and the repayment period may stretch to over ten years, which keeps the debtor caught in a debt trap for the time period. Moreover, with some HELOCs, the balance needs to be settled as the draw period ends.
There is also a borrowing limit of $100,000, although the net amount is dependent on the borrower’s creditworthiness and equity. A bank will usually allow up to 85% borrowing on the home’s appraised value, minus what is owed on its first mortgage.
Carl has years of experience helping people tackle debt. As a Senior Financial Advisor, he knows the ins and outs of debt consolidation and debt management. He holds a Masters Degree in Finance and according to him, not all debt problems are the same and that’s why it’s important to take a look at the different options available for your situation.