Homeowners with debt other than their mortgage might be wondering if they can use their home equity to consolidate their debt. With property values soaring, many homeowners are taking advantage of increased equity in their home to pay for renovations, buy a new family vehicle or go on a holiday. You could also eliminate your high-interest debt with a low interest rate home equity loan.
What is a home equity loan?
A home equity loan is a loan secured by your home that can be used for nearly any purpose, including consolidating multiple loans or credit card debts.
Firstly, let’s explain how a home equity loan works in Australia. You could be approved for a home equity loan (sometimes known as a “cash out loan”) if you have enough usable equity on your property. Well, what is usable equity you ask? Usable home equity is calculated as a percentage of your property value (what the bank values your property at) less any debt secured to your property. For instance, if your home is valued at $650,000, then the bank can lend you 80% of that value (which comes to $520,000). If you still owe $250,000 on your mortgage, then your usable home equity is reduced to $270,000. We can help you understand how much equity you can unlock for a home equity loan that provides the most cost-effective outcome.
A home equity loan can be either open-ended or closed-end. A closed-end loan is ideal 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.
Should I use a home equity loan to consolidate debt?
Home equity loans and HELOCs generally have low interest rates, so they are ideal for homeowners who want to save money by refinancing their high-interest debts at a lower interest rate. By doing this, you may be able to pay off a credit card with an 18% interest rate with a home equity loan that has an interest rate below 2%.
Home equity loans and home equity lines of credit are best for those who have significant equity available in their homes, typically at least 15-20%.
However, using home equity to consolidate debt is not the right choice for everyone. If you struggle with responsible debt management or repayment schedules you could find yourself at risk of a foreclosure on your home. Please read on for the pros and cons of using home equity for debt consolidation, to see if this is something you could consider for your debt consolidation needs.
Pros of using home equity for debt consolidation
Using your home equity for debt consolidation can be a smart move for a number of reasons:
1. One streamlined payment
When you consolidate your debt by using your home equity, you can simplify your life. Instead of multiple bills every month, you can have one monthly payment that you can pay on time. This can ease stress and simplify your finances.
2. Lower interest rate
A home equity loan generally comes with a lower interest rate than other types of loan products. This is because your home serves as collateral for the loan. If you have outstanding debt on a credit card, a personal loan, student loans or other debts, consolidating with a home equity loan could make it cheaper to pay off those debts. A lower interest rate on one consolidated loan will mean less total interest paid over the course of the loan.
3. Make lower monthly payments
With a lower interest rate, using a home equity loan for debt consolidation will generally lower your monthly payments. If you have a tight monthly budget, the money you save each month could be exactly what you need to get out of debt. 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.
4. Cons of using home equity for debt consolidation
While a home equity loan for debt consolidation might work for some people, it’s not necessarily the best choice for everyone. This is because:
5. Your home is collateral
The main consideration in using your home’s equity for debt consolidation is that your home serves as collateral for a home equity loan. While this means a lower interest rate, it also means that if you default on your new home equity loan, you may face foreclosure on your home. If you’re having trouble making existing payments, you will need to consider a range of financial factors to see whether putting your home as collateral is right for you.
6. Increased debt load
While a home equity loan can consolidate your debt, it will only help you decrease your debt 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, manage to pay it off but then continue to rack up more credit card debt, you’ll then owe a home equity loan payment as well as credit card payments.
7. Possible fees
A home equity loan will use your home’s current value to calculate how much you can borrow through a lender. To do this, you may need to pay for a new valuation of your property. When taking on a home equity loan, you may have some fees attached to it because it is considered a second mortgage.
If you have a lot of debt to consolidate, paying these extra fees may still make sense, but it’s wise to compare the fees you would have to pay with the amount you’d ultimately save in interest. If savings do not outweigh the fees associated with the debt consolidation, you may be better off looking at other debt consolidation measures.
How do I get a home equity loan for debt consolidation?
If you’ve read through these pros and cons and decided a home equity loan is for you, then applying for a home equity loan for debt consolidation is quite similar to applying for a mortgage. You will be required to provide income and employment information and possibly have a property valuation as part of the application process. There are no differences in the application process for a home equity loan or a HELOC. The process is similar to a mortgage refinance, however, the lender will often send debt payments directly to other lenders in order to consolidate the debt into the new home equity loan.
The main differences between a home equity loan and a HELOC are how borrowers receive their funds and how interest is charged.
A home equity loan can have a variable or fixed rate and is disbursed to the borrower in one lump sum. The borrower begins making regular monthly repayments immediately.
With a HELOC, the interest rate is typically variable. The loan starts with a draw period generally lasting 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 20 years.
If yu’ve decided that a home equity loan is your best option for consolidating debt, talk to us to get started.