Can you use a home equity loan to consolidate debt? If you’re a homeowner with high-interest debt, you might be wondering if you can use the equity you’ve built up in your property to transform your debt into a single, more manageable repayment.
With property values soaring, many homeowners are looking to take advantage of increased equity in their homes. Some are using this to pay for renovations, buy an investment property or go on a holiday. But there is another option. You can also eliminate your high-interest debt with a low-interest rate loan product.
But what exactly is equity? What should you know about usable equity? And should you use an equity loan to consolidate high-interest personal debts?
What is Equity?
First of all, what is equity? It’s the difference between your current property value and the outstanding balance on your home loan. For example, imagine you originally applied for a home loan valued at $500,000. Since then, you’ve managed to reduce the outstanding balance down to $450,000. However, property prices have also increased significantly and your home is now valued at $700,000.
By subtracting the mortgage balance ($450,000) from the new property value ($700,000) you can calculate how much equity you have ($250,000).
Understanding Usable Home Equity
However, there is an important difference between ‘equity’ and ‘usable equity’. To be approved for a home equity loan, you’ll first of all need to have sufficient usable equity.
So, what is usable equity? Usable home equity is calculated as a percentage of your property less your current debt. Essentially, a lender won’t let you borrow the full difference between what your property is worth and your current mortgage balance – it’s just too high risk for the lender. If something were to go wrong and you were to default on the loan, there’s no guarantee they’d be able to recoup the costs.
Usable equity is calculated as 80% (without paying lenders mortgage insurance) of your property’s current value, minus your existing mortgage balance. For example, if your property is valued at $700,000 and your mortgage balance is $450,000, the usable equity would be calculated as follows: (80% of $700,000) – $450,000 = $110,000 usable equity.
The easiest way to get an accurate estimate of how much equity you can unlock is to ask an experienced mortgage broker to assess your personal situation.
What is a Home Equity Loan?
Now that we understand how usable equity is calculated, what is an equity home loan? It’s a cash-out loan product that is secured by your existing home. This kind of loan can be used for nearly any purpose, including consolidating multiple loans or credit card debts into a single, low-interest repayment.
An equity home loan can be either an open-ended line of credit or what’s referred to as a closed-end loan. A closed-end loan is perfect for making a single purchase with a set amount of money. This is usually a lump sum payment similar to your initial mortgage and is often used for things like home renovations. On the other hand, an open-ended home equity line of credit (HELOC) is ideal if you require ongoing funds that are available to replenish and redraw upon, similar in function to a credit card but with greater borrowing power.
Can Low Home Equity Loan Rates Help to Consolidate Debt?
Equity home loans and HELOCs generally have lower interest rates (compared to credit cards or personal loans), so they are ideal for homeowners who want to save money by refinancing their high-interest debts for one with a lower interest rate. With an equity loan, you can exchange a credit card debt with a 21% interest rate for home equity loan rates as low as 7%. This could save you a substantial amount of interest on each monthly repayment.
Equity home loans and HELOCs can be ideal for those who are struggling to manage multiple high-interest forms of debt. Thanks to reduced home equity loan rates, it may be easier for you to pay off your debt without the risk of defaulting steadily.
What to Consider Before Applying for an Equity Home Loan
Using home equity to consolidate debt is not the right choice for everyone. If you struggle with responsible debt management or repayment schedules, then an equity loan could ultimately put you at risk of your lender repossessing your home.
Other alternatives to your lender repossessing your home may include:
- Reinstatement: You will pay the lender the entire amount you owe them with the addition of late fees and penalties on a certain date. If your mortgage is a temporary problem then you can explore this option.
- Refinancing: You can look into refinancing if you want a better rate, more affordable payments and have a passable credit rating and acquired enough home equity.
- Communicate with your lender: If unexpected changes like job loss or injury enter the picture then you should chat with your lender to help you qualify for financial hardship to help out with financial matters until things get better.
The Impact of Taking Out A Home Equity Loan on Your Credit Score
Taking out a HELOC can impact your credit score positively but it also depends on how you utilise your credit – timely payments will assist you in paying off your HELOC without issues.
Given that a substantial asset secures a home equity line of credit, it is generally perceived by credit rating agencies as a less risky form of debt than unsecured obligations such as credit card or personal loan debt. Consequently, the responsible management of a HELOC may have a positive influence on the borrower’s credit score.
As with any major financial decision, it’s important to carefully consider the various pros and cons before going ahead. If you’re wondering if this is something that could be worth trying, start by considering the following advantages and potential drawbacks of using your home equity to secure a debt consolidation loan.
Pros of Using Home Equity for Debt Consolidation
There are pros and cons of using home equity for debt consolidation.
Using your home equity for debt consolidation can be a smart move for a number of reasons, including:
1. One Streamlined Payment
When you consolidate your debt by using your home equity, you can simplify your life. Instead of juggling multiple bills every month, you can have one monthly payment that you can pay on time. This can ease financial stress and simplify your finances.
2. Lower Interest Rates
An equity home loan generally comes with a lower interest rate compared with other types of loan products like a loan for investment. This is because your home serves as collateral for the loan. If you have outstanding debt on a credit card, a personal loan or other financial obligations, then consolidating this assorted debt into an equity home loan could make it easier to pay off those debts. A lower interest rate on one consolidated loan could also mean less total interest paid over the course of the loan.
3. Reduced Monthly Repayments
Thanks to a lower interest rate, using an equity home loan for debt consolidation will generally reduce your monthly repayments. If you already have a tight monthly budget, the money you save by consolidating could be exactly what you need to pay off the debt successfully. It is important to note that extending the length of your loan term could cause you to pay more interest overall, so you need to ensure you have sound financial advice to see whether this is the right move for you.
Cons of Using Home Equity for Debt Consolidation
While an equity home loan for debt consolidation might work for some people, it’s not necessarily the right choice for everyone. This is because:
1. Your Home is Collateral
The main consideration in using your home equity for debt consolidation is that your property serves as collateral for the loan. While this gives you access to a lower interest rate, it also means that if you default on your loan, you may face repossession on your home. If you’re having trouble making existing payments, you should consider a range of financial factors to see whether putting up your home as collateral is right for you.
2. Potential for Increased Debt Load
While borrowing against your equity can help you to consolidate debt, it will only be beneficial in the long term if you also limit the spending that caused that debt to pile up in the first place. For instance, if you have a mountain of credit card debt, you could use an equity loan to pay it all off. However, if you then rack up more credit card debt, you’ll end up having to make repayments on an equity home loan, plus a credit card.
Can a Home Equity Loan Calculator Help?
If you’re wondering how an equity loan could reduce your repayments, then using a home equity loan calculator may be beneficial. By factoring in potential loan amounts, interest rates and loan terms, you should be able to calculate potential monthly savings, as well as the total interest paid over the life of the loan.
This will help you to assess whether consolidating debt with an equity mortgage is a financially sound choice.
With our calculator, you can do the following:
- Enter the amount you’re thinking of borrowing or use the slider to explore different amounts.
- Choose the loan type that fits your needs.
- Now, customise your loan: Use the sliders to adjust the loan term (how long you’ll be paying it back) and the interest rate. You can also type in the numbers if you prefer.
- Select the payment schedule that works best for you.
- Check on the repayment type you’d like to learn more about.
How Can You Apply for an Equity Loan for Debt Consolidation?
Applying for a home equity mortgage for debt consolidation is similar to applying for a traditional mortgage (and there are no differences in the application process for a home equity loan or a HELOC). You will be required to provide income and employment information and possibly have a property valuation as part of the application process.
Once approved, the settlement process is similar to a mortgage refinance.
What Is the Difference Between a Home Equity Loan and a HELOC?
The main differences between an equity home loan and a HELOC are how borrowers receive their funds and how interest is charged.
- Home Equity Loan: A home equity mortgage can have a variable or fixed interest rate and is disbursed to the borrower (or existing lenders) in one lump sum. The borrower begins making regular monthly repayments immediately.
- Home Equity Line of Credit: With a HELOC, the interest rate is typically variable. The loan starts with a draw period generally lasting 5-10 years, during which the borrower can draw on the line of credit as needed and make interest-only payments. Once the draw period ends, the repayment period begins. The borrower then begins paying off both the principal and interest for a term that usually lasts up to 20 years.
Talk to SCF Solutions About a Home Equity Loan
If you think that a home equity loan is an option for consolidating debt – or you need help deciding – then your next step should be to contact an experienced mortgage broker. We can help you with an accurate assessment of your current financial situation and help you find the right solution for your debt consolidation.
The team of brokers at Sunshine Coast Financial Solutions would be happy to help you get started on your debt consolidation journey. Don’t put it off any longer – contact us today and discover personalised debt solutions tailored to your needs.
Meet Chris Wilson, the heart of Sunshine Coast Financial Solutions (SCFS). With over a decade of experience in finance, Chris started his journey as a broker with Aussie Home Loans in 2009. His dedication earned him the title of Rookie of the Year in 2010. By 2011, he was ready to build a business based on trust and strong partnerships.
