Should I Use a Home Equity Loan for Debt Consolidation?

What Is a Home Equity Loan?

A home equity loan is a type of loan that lets you borrow against your home's equity and pay it back over time. Equity in your home is the market value of your home minus your mortgage balance. Or, said another way, the equity in your home is the amount of value of your home you own free and clear.

Example: If you owe $225,000 on your mortgage, and your home is now worth $525,000, you have $300,000 in equity. Since you can typically borrow 75% to 85% of your home's equity with a home equity loan, you may be able to get a loan for $225,000 to $255,000.

Interest rates are fixed on home equity loans, and the loan is paid back in monthly installments, typically over a term of five to 30 years. Home equity loans are considered second mortgages, and their payments are separate from your existing mortgage payments.

Learn more: What Is a Second Mortgage?

How to Consolidate Debt With a Home Equity Loan

Consolidating debt is the process of combining multiple balances into one, typically with a new loan or credit card that offers more favorable terms or a lower interest rate. A home equity loan is a common choice for debt consolidation thanks to long repayment terms and fixed, low rates—especially for borrowers with good to excellent credit.

To consolidate your debt with a home equity loan, follow these steps:

1. Evaluate Your Debt

First, carefully consider your current debt to see if debt consolidation makes sense financially. For example, if consolidating your debt helps you pay it off sooner or lowers your monthly payment, it could be the right choice. But if you're able to pay off your existing debt in less than a year without a loan, it might not be worth taking out a loan. Or, if your credit is less than stellar, you may not qualify for a lower interest rate and may be better off using a debt payoff strategy, like the debt avalanche or debt snowball methods, to pay down your debt.

2. Determine How Much You Need to Borrow

List each account you plan to pay off with your debt consolidation loan. Note each account's payoff amount, interest rate and your monthly payment. Then, add up the total payoff amounts to estimate how much you need to borrow. Next, look at your current monthly payments to see how much you've been spending each month. This can help you figure out how much you can afford to pay for a monthly loan payment.

3. Check Your Credit

Most lenders require a FICO^® Score^☉ of 680 or more for a home equity loan, while some prefer a score of 720 or higher. But if you have lots of equity, a sizable income or a low debt-to-income ratio (DTI), you may be able to get a home equity loan with a FICO^® Score below 680.

Knowing what range your credit score falls into can help you understand what lenders see when evaluating your application and setting your rates. Start by accessing your Experian credit report and FICO^® Score for free. Free weekly copies of your credit reports from the other two consumer credit bureaus, Equifax and TransUnion, are also available at AnnualCreditReport.com. Look over your report for issues and, if necessary, take steps to improve your credit.

Learn more: Can You Get a Home Equity Loan With Bad Credit?

4. Check Your Home's Equity

To calculate your home's equity, subtract your mortgage balance from your home's market value. Keep in mind that real estate market values fluctuate, so the only true way to know your home's value is through a professional appraisal (lenders typically require this during the formal application process). But websites like Zillow, Redfin and Realtor.com offer home values that can give you an idea of how much your home is worth.

5. Shop Around for Lenders

Home equity loans are available from traditional financial institutions, like banks and credit unions, as well as online mortgage lenders. As you shop around, you can prequalify with lenders without impacting your credit. This allows you to compare interest rates, loan amounts, monthly payments and other terms to find the best overall value. Be sure to look carefully at what each lender charges for closing costs, which often range from 2% to 5% of the loan.

6. Apply for a Home Equity Loan

Once you decide on a lender for your home equity loan, here's how to apply:

1. Collect your documents. Lenders typically need information about your credit, employment, income and more. Save time by having important information handy, such as W-2s, pay stubs, mortgage documents and proof of homeowners insurance.
2. Fill out the application. You may need to submit your home equity loan application online or work with a lender in person.
3. Wait for approval. It can take a few days up to a few weeks for your application to go through the underwriting process. The lender will review your finances and credit and usually require a home appraisal to accurately determine your home's value. Expect to pay a fee of $300 to $450 for the appraisal. Respond to lender requests quickly to keep underwriting moving along. If you're approved, you'll begin steps to close on the loan.
4. Close on your home equity loan. After underwriting is complete, your lender will inform you of the final approval, loan amount, interest rate and monthly payments. Read over your loan documents carefully to make sure you understand and agree with the terms. If you need clarification, ask questions before you sign. Once you're satisfied, sign the loan documents. Keep in mind that you'll have a three-day rescission period after closing to cancel the loan without penalty.

7. Receive Funds and Pay Off Creditors

Home equity loans are paid out as a lump sum. Depending on the lender, you may have the option for the lender to pay off your creditors directly or deposit the funds into your bank account so you can pay off your debts yourself. If you choose to have the lender settle your debts, you'll need to provide them with account details, payoff amounts and other required information. If you plan to pay creditors yourself, pay off your accounts right away before additional interest accrues and changes your final payoff amounts.

8. Make On-Time Payments

Your payment history is the most important factor of your credit score, so it's important to pay your home equity loan as agreed. Making on-time payment not only keeps your loan current, but it can also help improve your credit in the long run.

Types of Debt to Consolidate With Home Equity

Home equity loans can be used to consolidate many different types of debt. Some of the most common include:

• Credit card debt: If you're carrying balances on multiple high-interest credit cards, you can use a home equity loan to pay off your balances and potentially reduce your overall interest costs. Plus, you'll only have to remember one monthly payment.
• Personal loans: You can use a home equity loan to pay off personal loan balances. This may be a good option if your credit situation has improved and you qualify for a better interest rate, want a lower monthly payment or prefer to stretch your payments out over a longer loan term.
• Medical bills: As health care costs continue to climb, more Americans report the need to borrow money in order to cover their medical bills. If you can't cover your medical bills or you paid them off with a high-interest credit card originally, a home equity loan could help you pay off that debt. However, your health providers may allow you to make monthly payments on your medical debt without incurring interest. Before using a home equity loan for medical payments, find out your providers' payment policies.

Types of Debt to Avoid Consolidating With Home Equity

Not all debt should be consolidated with a home equity loan. Here are some common types of debt to avoid consolidating with a home equity loan:

• Car loans: It's generally not advisable to pay off your car as part of debt consolidation. Home equity loans typically have much longer terms than auto loans, so you could pay interest past the life of your car. Refinancing your car loan is usually a better option.
• Luxury expenses: Using a home equity loan to cover a splurge expense, like a vacation, can cost you in the long run. Saving up for a big-ticket item like a vacation is usually a better choice.
• Mortgages: It's likely more advantageous to refinance your mortgage instead of using a home equity loan if you're looking for a better rate or terms on your existing mortgage.

Pros and Cons of Consolidating Debt With Home Equity

Using a home equity loan to consolidate debt offers some advantages, but there are also disadvantages to consider.

Should You Use Home Equity for Debt Consolidation?

Using a home equity loan for debt consolidation can be a smart move in the following situations:

• You have a stable income. Make sure you can afford your monthly payments. Otherwise, your home could be on the line and your credit could take a hit. Most lenders also require a debt-to-income ratio of 43% or less to qualify.
• You will not run up more debt. If you're confident you can pay off what you owe without racking up new debt, using a home equity loan may be a good choice. Otherwise, consider working on changing your spending habits first.
• Your home has enough equity. Home equity loans generally require you to have sufficient equity to qualify—at least 15% to 20% of the home's value.
• You'll save a significant amount in interest. If you carry many high-interest balances and are approved for a low interest rate on a home equity loan, you could save in the long run.

Alternatives to Using a Home Equity Loan for Debt Consolidation

A home equity loan isn't the only financing option for debt consolidation. Common alternatives include:

• Balance transfer credit cards: Borrowers with excellent credit may qualify for credit cards offering 0% introductory APRs on purchases for a limited time, generally 12 to 21 months. If you can pay off your debt within this period, you'll save more in interest and avoid carrying a loan for a longer term.
• Personal loans: Personal loans can be used for nearly any purpose, and since they're typically unsecured, your home won't be at risk.
• Cash-out refinancing: A cash-out refinance replaces your existing mortgage with a new, larger mortgage, allowing you to cash out up to 80% of your equity. These are more popular when current interest rates are lower than your existing mortgage rate.

Frequently Asked Questions

The Bottom Line

Home equity loans can be used for consolidating debt, like high-interest credit cards and medical bills. But they often have strict lender requirements, come with closing costs and fees and could cost you your home if you can't make the payments. It's important to carefully weigh the pros and cons before deciding on a home equity loan for debt consolidation.