Using Home Equity Loan To Pay Off Credit Card Debt

Home equity loans typically have relatively low interest rates, especially compared with unsecured forms of debt like credit cards. If you are one of millions of Americans saddled with consumer debt, taking out a home equity loan to pay off your higher-interest debts can be a very attractive option.

KEY TAKEAWAYS
  • Consolidating higher-interest-rate debt from a credit card or personal loan to a lower-interest-rate home equity loan can help you pay off your debt faster and for less money overall.
  • If you can’t make payments on your home equity loan, you could lose your home in foreclosure.
  • If your home’s value decreases below the balance on your home equity loan and mortgage, you may be unable to sell your home or move.
  • Make sure to address the causes of your high-interest debt so that you don’t end up trapped in a home equity loan debt cycle.

Pros and Cons of Using a Home Equity Loan to Pay Off Debt

Pros
  • Interest rates for home equity loans are significantly lower than rates on many other types of debt. If you are able to afford only a fixed amount every month to pay off debt, taking out a home equity loan to pay down your loan balances can help you settle debt more quickly. A lower interest rate means that a greater portion of your monthly payment each month goes toward paying down the principal. From a purely financial perspective, paying off your higher-interest debts with a lower-interest home equity loan will save you the most money in the long run.
Cons

There are several cons to using a home equity loan to pay off debt, and they shouldn’t be ignored. While you may intend to use your home equity loan to settle debt, you could find yourself using your lump sum frivolously and end up in even more debt. If you use your home equity loan to settle your debt and end up unable to pay down your home equity loan, you could lose your home to foreclosure. While defaulting on your unsecured debt could hurt your credit for years, defaulting on your home equity loan will hurt your credit and make you homeless.

Even if you use your home equity loan responsibly and make payments every month, you could end up underwater on your loans if your home value decreases. In this situation, you may be unable to move from or sell your home for years while you pay down your loans or wait for your home’s value to increase.

Behavioral Changes

Consolidating higher-interest debt into a lower-interest home equity loan may be the smartest thing from a mathematical perspective, but don’t ignore emotional and behavioral concerns. Daniel Yerger, a certified financial planner and owner of MY Wealth Planners, cautions that “consolidating high-interest debt into a home equity loan can be a great money-saving technique, but it’s only helpful if the underlying cause of the original debt is addressed.”

If you have a high balance of consumer debt and are using a home equity loan to pay it off, make sure that you address the causes of your high balance so you don’t end up in the same situation a few months or years ahead. Consider downloading a budgeting app to track spending, and make sure that you’re using money for things that you truly value. Make sure to build up savings in an emergency fund so that you aren’t running up balances on high-interest credit cards when something comes up.

What is debt consolidation?

Debt consolidation is taking out a new loan to pay other loans. Taking out a home equity loan to pay off older debts is a form of debt consolidation.

Do I need good credit for a home equity loan?

While every lender’s requirements vary, you’ll typically need good credit to get approved for a home equity loan. Because home equity loans are secured by using your home’s equity as collateral for the loan, you may be able to be approved for a home equity loan even if you don’t qualify for an unsecured loan such as a personal loan.

Can I get approved for a home equity loan if I have a lot of credit card debt?

Yes, you can get approved for a home equity loan even with a lot of credit card debt as long as your income is high enough and you have sufficient equity in your home. Lenders look at multiple factors when you apply for a home equity loan, such as:

  • Typically wanting a combined loan-to-value (CLTV) ratio of 85% or less. This means that your mortgage balance plus the home equity loan balance divided by your home’s value equals less than 85%.
  • Considering your debt-to-income (DTI) ratio. Your DTI ratio is the total of your monthly debt payments divided by your gross monthly income. Most lenders prefer your DTI ratio to be 36% or less.

Home Equity Loan to Pay Off Credit Cards

Paying off high-interest credit card debt with a low-interest home equity loan may be a good strategy to relieve financial pressure — but it can also put your home at risk.

Using a home equity loan to pay off credit card debt can be a smart move, but it’s not without risk. Since credit card debt usually has a much higher interest rate than mortgage debt, you could save money and get out of debt faster with this strategy.

The big risk is that if you can’t repay the home equity loan, you could lose your home. Not repaying your credit card debt can also have serious consequences, but you’re less likely to lose your home.

Here’s what you need to know about paying off your credit card debt with a home equity loan:

  • How to use a home equity loan to pay off credit card debt
  • Home equity loan limits
  • Benefits of using a home equity loan to pay off credit card debt
  • Drawbacks to using a home equity loan to pay off credit card debt
  • How to pay off credit card debt without a home equity loan
  • How to pay off credit card debt without a loan
  • Is a home equity loan to pay off credit cards right for you?
How to use a home equity loan to pay off credit card debt

To pay off credit card debt with a home equity loan, you’ll first need to qualify for a home equity loan. Home equity is the part of your home’s value that you don’t owe to the bank. For example, if your home is worth $350,000 and you owe $250,000 on your first mortgage, your equity is $100,000, or about 28.5%.

A home equity loan, also called a second mortgage, will let you access a portion of that $100,000 as a lump sum. You can use the money however you want and take up to 30 years to repay it.

The long repayment period and fixed, lower interest rate can immediately reduce your financial stress. And if you avoid taking on new credit card debt, your home equity loan can help you make steady progress toward getting out of debt for good.

Home equity loan limits

On average, the most you can usually borrow between your first and second mortgages is 80% of your home’s value. This percentage is called your combined loan to value ratio, or CLTV.

Some lenders have stricter loan requirements and limit borrowing to 70% of your CLTV, while others have looser requirements and may let you borrow up to 90%. Your financial profile will also affect how much you can borrow.

Here’s how to calculate your home equity:

Home value － Mortgage principal balance = Home equity

So, let’s assume again that your home value is $350,000, your mortgage principal balance is $250,000, and your home equity is $100,000. With a $250,000 mortgage balance, you’re already borrowing against 71.5% of your home’s value. The strictest lenders that limit CLTV to 70% wouldn’t approve your home equity loan application.

Others might let you take out a home equity loan (or a home equity line of credit) for anywhere from $30,000 (80% CLTV) to $65,000 (90% CLTV).

Tip: Lenders want you to keep some equity because when your own money is at stake, you’ll do more to avoid foreclosure. It assures them that you’re committed to keeping your home and they won’t lose money on your loan.

Along with having enough equity, you’ll also need to have:

  • A credit score of at least 620
  • Verifiable income
  • A debt-to-income ratio of 43% or less
Benefits of using a home equity loan to pay off credit card debt

Using a home equity loan to pay off credit card debt can have several benefits:

  • They offer lower interest rates than credit cards. The typical credit card interest rate for someone carrying a balance is approximately 17%, according to the Federal Reserve. But home equity loan interest rates can run as low as 3% for highly qualified borrowers.
  • They have a long repayment period. A home equity loan’s term can be as long as 30 years.
  • You’ll enjoy lower monthly payments. A lower interest rate plus more time to repay your loan can improve your cash flow.
  • You can borrow more money. Depending on how much home equity you have, you may be able to borrow more with a home equity loan than with other options, like a personal loan.
  • They have fixed rates. The unpredictability of a variable APR on a credit card can make it harder to pay off debt. A home equity loan will lock in your interest rate for the entire repayment period.
  • You can also pay off other debts with a home equity loan.
Drawbacks to using a home equity loan to pay off credit card debt

Using a home equity loan to pay off credit card debt has its drawbacks too:

  • It won’t save you from bad habits. If you haven’t learned new money management skills to replace the habits that got you into debt, using a home equity loan to pay it off will only be a temporary fix. (Of course, bad habits aren’t the only reason people get into credit card debt: illness, unemployment, and emergencies can also be the cause.)
  • Your home will serve as collateral. A home equity loan is secured by your house, so if you default on the loan, there’s a chance it can be foreclosed on. Credit cards don’t have collateral. That said, if you default on your credit card bills, a debt collector could obtain a judgment against you and force the sale of your home, depending on your state’s laws and how much equity you have.
  • It might be harder to sell. The more you owe on your home, the greater your risk of owing more than your home is worth if the market declines. This situation is called being underwater. If you’re underwater and want to sell your home, you’ll have to tap into your savings to pay off your mortgage.
  • You might pay more interest in the long run. Despite getting a substantially lower interest rate on a home equity loan, if you take a lot longer to pay it off than you would have taken to pay off your credit card, you might not achieve the savings you expected.
  • You might pay closing costs. Any closing costs you have to pay will reduce your savings from refinancing your credit card debt. Some lenders don’t charge closing costs on home equity loans, but they might bundle these costs into a higher interest rate.

The Bottom Line

Consolidating higher-interest debt into a lower-interest home equity loan can help you pay off debt faster and cheaper. Make sure that you understand the risks of a home equity loan before you sign up for one, and set yourself up for future success by addressing your money habits first.