Paying down high-interest credit card debt or other loans can be tough, especially if you have other responsibilities like a student loan, car loan — and even a mortgage payment.
If you’re “house rich,” meaning you have a lot of equity in your home, but “cash poor,” you might consider using a home equity loan to pay off debt. Keep reading to find out what a home equity loan is and how to get one for just about anything — whether it’s paying off high-interest debt, making home improvements, or tackling other major expenses.
- What is a home equity loan?
- How does a home equity loan work?
- Types of home equity loans
- Pros and cons of using home equity to pay off debt
- How to get a home equity loan in 4 steps
- Home equity loan alternatives
What is a home equity loan?
Home equity loans let you borrow against the equity in your home. Because you’re using your home as collateral, they can typically be easier to qualify for than other loans.
Not only that, but a home equity loan can provide access to a sizeable amount of cash in one lump sum, often at a more affordable interest rate than a personal loan.
Home equity loans are often used to make home improvements, and there can be tax advantages when doing so. But you can use a home equity loan for anything that you’d use a personal loan for — like as a debt consolidation loan.
How does a home equity loan work?
A home equity loan is a second mortgage. You’re borrowing against the equity in your home, which gives the lender the right to foreclose on your property if you can’t pay them back.
But because you’re putting your house up as collateral, you might qualify for a lower interest rate than you might be offered with a personal loan. That’s why it can be advantageous to use a home equity loan to pay off debt.
The amount that you can borrow will be limited by the amount of equity you have in your home, and how much of your monthly income is available to repay a loan.
Types of home equity loans
You have three main options for tapping the equity of your home:
- Traditional home equity loan: You take out a second mortgage and receive 100% of the loan proceeds up front, and pay the loan back over a set period of time, typically over 10 or 15 years.
- Home equity line of credit (HELOC): You’re approved to draw money against your home as needed, up to a predetermined limit, making interest payments only on the amount you draw.
- Cash-out mortgage refinance: You pay off your existing mortgage with a new mortgage that’s big enough so that there’s money left over that can be used to pay off other debts, or be stashed in the bank.
Pros and cons of using home equity to pay off debt
If you’re taking out a new loan to pay off an existing loan, the goal is usually to save money in the long run — to reduce the total amount you’ll repay.
But with some types of home equity loans, it can be hard to know what your total repayment costs will be. If the interest rate is variable and the repayment term is open ended, you can only make an educated guess.
A traditional home equity loan works pretty much like your first mortgage, which is the mortgage you took out as a homebuyer. It has a fixed repayment term, and most lenders offer fixed interest rates.
Here are the pros and cons of paying off existing debt with each type of loan that’s used to tap home equity.
Traditional home equity loan
- Traditional home equity loans have fixed repayment terms of 5 to 30 years, and the interest rate is also usually fixed
- Because you’re putting your house up as collateral, you might get a better interest rate than you could qualify for with a personal loan
- You know exactly what your monthly payment will be, how long you’ll be making it, and what your total repayment costs will be
- Knowing what your total repayments costs will be can help you determine whether you’ll save money if you take out a home equity loan to pay off debt
- Because a home equity loan is a second mortgage, interest rates won’t be as low as what you’re used to seeing advertised for first mortgages
Rates on first mortgages are about two percentage points lower than second mortgages because first mortgages are less risky to the lender, who is first in line to get paid if a home ends up in foreclosure.
Home Equity Line of Credit (HELOC)
- With a HELOC, you only borrow what you need and you don’t pay interest charges on the portion of your draw limit that you’re not using
- HELOCs are typically available only from banks and credit unions
- Interest rates on HELOCs are usually variable, making it harder to know what your monthly loan payments will be
- A HELOC is an open-ended loan, making it harder to predict how long you’ll be making payments, and what your total repayment costs will be
A HELOC can be a great tool for managing your finances if your income and expenses are unpredictable. You only borrow what you need, when you need it and aren’t assessed interest on the unused portion of your borrowing limit.
But if you already have a set amount in mind that you want to borrow to pay off debt, a home equity loan or cash-out refinance might work just as well.
- A cash-out mortgage refinance is a first mortgage, so interest rates are often lower than what you’d pay for a home equity loan or HELOC
- You’ll usually have a choice of a fixed- or variable-rate loan, and options to pay the loan back over 15 or 30 years
- To get cash out of your home, you also have to pay off your existing mortgage, which means a larger total loan balance
A cash-out mortgage refinance can be a great deal if you’re getting a lower interest rate than your existing mortgage. Even if the interest rate on your new loan is higher than your existing mortgage, a cash-out mortgage refinance might be your cheapest source of credit. Just remember you’ll be paying that higher interest rate on the entire balance of your mortgage — not just the cash you’re taking out of your house.
How to get a home equity loan in 4 steps
If you’ve decided a home equity loan could be the right solution for you, here are the steps you can take to find the right loan.
1. Determine how much you want to borrow
Starting out with the amount of money you want to borrow can help you decide which type of loan is best for your needs and whether you can qualify for it.
2. Calculate how much home equity you have
To figure out the amount of equity you have in your home, subtract your current mortgage balance from the market value of your home.
For example, if your home’s value has been appraised at $300,000, and you only owe $150,000 on your mortgage, you have $150,000 in equity.
3. Figure out how much you can borrow
Most lenders won’t let you tap all of your home’s equity — they’ll want you to keep an ownership stake of at least 10% and in some cases 20% or more. In other words, the combined loan to value ratio (CLTV) typically can’t exceed 80% to 90%. The most common is 20% ownership and 80% CLTV.
To calculate CLTV, add the amount you want to borrow to your current mortgage balance, and divide by your home’s value. Let’s say I want to borrow money. I decide I want to borrow $50,000 and my current mortgage balance is $150,000. But my home is worth $300,000, so my CLTV is 67% — well within most lender’s limits.
4. Get interest rates from multiple lenders
To determine whether you’ll come out ahead by using a home equity loan to pay off debt, you should check your rates with multiple lenders. Every lender will use its own methods for evaluating you, so it can pay to use a website like Credible to compare prequalified rates.
When lenders provide you with rates, you’ll also get a good estimate of what it will cost to repay your loan, which can help you choose the right loan and lender.
Home equity loan alternatives
Even if you’re not worried about putting your house up as collateral, it’s also worth checking rates on personal loans. If you have a good credit score, rates on personal loans can be surprisingly competitive.
That’s especially true if you can afford the minimum payments on a loan with a shorter repayment term. The shorter the repayment period, the lower the interest rate offered by most lenders.
If you qualify for a low interest rate, both personal loans and home equity loans can be an affordable way to pay off higher-interest debt.