Pros and Cons of Using a Home Equity Loan to Consolidate Debt
Although you can use a home equity loan to consolidate debt, the big question is whether you should.
If you owe money to a lot of different creditors, you might be interested in consolidating it.
Debt consolidation involves taking out a new loan, hopefully with a lower interest rate, to help you pay off your current debt.
If you're approved for your new loan, you'll use the proceeds to pay back every creditor you currently owe money to. Instead of having many loans with multiple different monthly payments and interest rates, you will only have your new loan to pay.
For those who are consolidating debt, the big question is what type of new loan you'll take out. While you have many different options, a home equity loan is a popular choice. But before you borrow against your home, you need to consider the pros and cons of consolidating debt by using this type of loan.
Advantages of consolidating debt with a home equity loan
With a home equity loan, your house acts as collateral. The amount you can borrow will depend on a home appraisal. The biggest benefits of consolidating debt with a home equity loan include:
- A low interest rate: Home equity loans tend to have a lower interest rate than almost all other kinds of loans. Using a home equity loan makes it much easier to qualify for a loan that reduces the rate on your current debt.
- Lower monthly payments: In many cases, home equity loans are paid for over long periods of time. As a result, your monthly payment may be much lower than it would be if you kept your current debt or used another type of consolidation loan. Lowering your monthly payments can provide flexibility in your budget.
- A predictable payoff process: As long as you get a fixed-rate home equity loan, you'll know up front the total cost of paying your debt. And you will also know the payoff timeline so you'll be aware of the exact day your debt will be paid off.
Disadvantages of consolidating debt with a home equity loan
While these benefits can help make a home equity loan seem attractive, there are also some disadvantages.
- Your interest isn't necessarily tax deductible. Usually, the interest on mortgages is tax deductible if you itemize. However, interest on home equity loans is deductible only under certain circumstances when you've used the debt to improve the home. Although other types of debt consolidation loans also don't come with deductible interest, this can still come as a surprise if you're expecting to be able to deduct it with your home equity loan.
- Costs and fees could be high: There tend to be more upfront fees associated with getting a home equity loan than other types of loans. This can include the cost of an appraisal as well as loan origination fees.
- Getting a loan can be time consuming: While you can often get approved for a personal loan or balance transfer within days or even hours, it can take weeks to go through the home equity approval process.
- You need equity in your home. Equity is the amount your home is worth minus what you owe on the mortgage. Many lenders only allow the total combined balance of your mortgage and home equity loan to equal 90% to 95% of your home's value or less.
- You're putting your home at risk. Your home guarantees your equity loan. That means you could be foreclosed on if you miss payments. Other types of consolidation loans don't put your house in jeopardy like this.
For many people, these downsides outweigh the upsides. When that happens, personal loans or balance transfer credit cards end up being the better option for consolidating debt. If you're considering taking out a loan, be sure to consider each new loan type carefully so you can make a fully-informed choice about what's best for you.
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