Why a Home Equity Loan Is a Risky Choice for Debt Consolidation
Thinking about taking out a home equity loan to consolidate your debt? You need to be aware of the risks of this choice.Image source: Getty Images.
When you have a lot of high interest debt, it may be really tempting to take out a home equity loan to pay it off.
A home equity loan allows you to tap into the equity in your home so you can use the money to repay existing debts you owe. You can consolidate most or all of your debt into the home equity loan -- depending how much you owe -- so you have just one loan to pay. And, because a home equity loan typically has a low interest rate, you can significantly reduce the amount of interest paid over time.
While all of this sounds great, you need to think very carefully about whether it makes financial sense to use a home equity loan to tackle your debt. In particular there are a few really big risks you need to be aware of before you act.
When you use a home equity loan you put your house at risk
The first and most substantial risk you face when you take out a home equity loan to repay other debts is that you convert those debts to secured debts and you put your house on the line.
If you have credit card debt, personal loan debt, medical debt, or most other types of consumer debt, chances are it's unsecured debt. That means there's no collateral and no guarantee you'll repay what you owe except your promise to the creditor.
If you can't pay back the money you've borrowed, the creditor might sue you -- but creditors often don't bother because of the hassle and expense. Even if the creditor sues, if you can't pay, there's little the creditor can do. They might be able to go back to court to garnish your wages or have a lien put on your property, but they can't force you to sell your home or take your home to get paid back.
But, if you take a home equity loan, you're pledging your home as collateral. If you don't fulfill your promise to repay, you could lose your house when the lender forecloses. You don't want to take a chance of foreclosure, because losing your house is far more financially devastating than just damaging your credit with an unpaid loan that's sent to collections.
You risk getting trapped in your home, too
Another big risk associated with taking a home equity loan: you might get trapped in your house. Any time you tap into the equity of your home, you increase the chances you'll end up underwater or owing more than your house is worth.
If you're underwater on your home and can't sell the house for enough to pay back the money you owe, you won't be able to move unless you can bring a lot of cash to the table -- or unless your lender agrees to a short sale. A short sale damages your credit, lenders don't always agree, and it's much harder to find a borrower willing to put up with the red tape involved in getting to closing.
Home equity loan lenders do consider your loan-to-value ratio when deciding whether to lend to you. This is the amount you owe versus the value of your home. Still, if you're allowed to borrow and then property values fall, you may end up without enough equity and be put in this situation where you can't move to take a new job opportunity or cut your mortgage payments if there's a change in income.
You may not get enough money to pay off your debt
A final risk you face when you tap into your home equity is you may not get approved for a loan large enough to pay off all that you owe.
Because the amount you're allowed to borrow is based, in part, on what your home is worth, you'll probably have to pay for an appraisal to get a home equity loan. This can cost a few hundred dollars -- and when the appraisal is done, you may find out your home isn't worth as much as expected so you have limited equity to tap into.
In this situation, you may be able to pay off only a portion of your existing debt so you will still have multiple payments to make. You'll have already spent the money for an appraisal before finding this out, so you'll be stuck with that sunk cost and will have to decide if it's worth proceeding.
Consider other approaches to debt consolidation
Because a home equity loan is such a risky option for consolidating your debt, you may want to consider other alternatives instead.
A balance transfer credit card, for example, is quick, simple, and inexpensive to apply for. You can often get a 0% promotional rate for many months and, depending upon how large a line of credit you're extended, can pay off a lot of the existing debt you owe without converting it to secured debt. Personal loans may make more sense if you have a bigger debt balance to tackle that can't be paid down during a balance transfer card's promotion period. That's because many personal loans offer lower interest rates that could save you more over time.
By exploring all of your options for consolidating debt, you can find the right approach that doesn't put your home in jeopardy of being lost. You may still decide you're willing to take the risk because home equity loan interest rates can be so low, but go in with both eyes open so you aren't surprised if things go wrong.
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