Home Equity to Consolidate Debt: Weigh the Pros and Cons

Paying Off Debt, Personal Finance, Personal Loans
home-equity-to-consolidate-debt-weigh-the-pros-and-cons

You may be considering tapping your home equity to consolidate your credit card debt, a move that can lower your interest costs but has risks. Because of these risks, NerdWallet recommends that you reserve home equity for emergencies.

Consider these pros and cons:

Pros

  • Interest rates on home equity loans and lines of credit are much cheaper than those on credit cards
  • Home loan interest typically is tax deductible; credit card interest is not

Cons

  • With your house as collateral, you risk foreclosure if you can’t pay
  • If your home’s value drops, you could wind up owing more than it’s worth
  • Repayment terms can be 10 years or longer
  • The loan itself doesn’t address troublesome spending habits
  • Credit card debt is more easily discharged in bankruptcy

A homeowner with good credit is likely to have better options that don’t risk the house. A homeowner with shaky finances shouldn’t move unsecured debt that can be erased in bankruptcy to secured debt that can’t.

Consider other options first

The two questions to ask when considering any strategy to consolidate credit card debt are:

  • Will this plan allow me to pay off my consumer debt within five years?
  • Is my total debt less than half my gross income?

Why five years? That’s the maximum time you’d be required to make payments toward Chapter 13 bankruptcy or a debt management plan — after which your debt would be fully retired. Chapter 7 bankruptcy would wipe out your debt immediately and get you on a path toward restoring your credit.

A “no” answer to either question indicates too much debt. Your best option is to consult an attorney or credit counselor about debt relief, including debt management or bankruptcy.

Options for smaller debt loads that don’t put your home at risk include:

0% balance transfer card: For people with good or excellent credit, issuers offer balance transfer credit cards with introductory no-interest periods from six months to two years. This is usually the cheapest option for those who qualify.

Personal loan: For most borrowers, interest rates on debt consolidation loans are lower than rates on regular credit cards. The rate you get depends on your credit history and income.

>> MORE: Calculate personal loan rates

Home equity loan or HELOC?

If you’ve ruled out other options, weighed the pros and cons of consolidating with home equity and determined it’s the viable path, then it’s a choice of a home equity loan or a HELOC.

Home equity loans are a type of second mortgage based on the value of your home beyond what you owe on your primary mortgage. You get a lump sum of money, often with closing costs taken out, which you can then use to pay off your debt or for any other purpose. You’ll have a fixed monthly payment and a repayment schedule.

Pros:

  • Usually a low, fixed rate
  • Fixed loan payments can be easier to budget for than variable credit card payments
  • Know your loan’s exact payoff date
  • No temptation of a revolving credit line

Con:

  • Upfront closing costs can be high

HELOCs are second mortgages structured like credit cards. Instead of getting a lump sum, you draw down money you need —  to pay off credit card balances, for example — using checks or a debit card linked to the credit line. You pay interest only on the credit you use, often at rates several percentage points lower than average rates on credit cards.

Pros:

  • Usually a low, variable rate
  • Some have no or low closing costs

Cons:

  • Adjustable rates mean payments could go up
  • Harder to budget for
  • Easy access to credit line can sabotage budgeting efforts
  • Interest-only payment option can lead to deeper debt

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Jeanne Lee is a staff writer at NerdWallet, a personal finance website. Email: jlee@nerdwallet.com. Twitter: @jlee_jeanne.