Paying Off Debt Using Home Equity - Is It Worth It?
Financial issues are one of the most commonly reported causes of stress. This can be particularly true when an individual carries many high-interest debts that they struggle to make payments on.
While many debt reduction solutions exist, debt consolidation is a preferred strategy for getting debt under control. Out of the debt consolidation options, one option available to homeowners is a home equity line of credit (HELOC).
HELOC is a line of credit made available to homeowners based on the equity they have in their property.
How To Calculate Home Equity
In simple terms, equity can be thought of as the value of an individual's ownership stake in their home. Calculating one’s equity stake is simple and can be worked out as follows.
|Current Appraised Value Of Home - Mortgage Balance = Home Equity.|
For example, let us say an individual's home is worth $500,000 and they currently owe $220,000 on their mortgage. The amount of equity they have access to would therefore be $280,000. Importantly, if the current value of one’s home is less than what they owe on their mortgage the homeowner does not have access to any equity.
Paying Off Debt Using Home Equity - How It Works
Traditional debt consolidation loans typically involve taking out a single loan to pay off all other debts in full. The consolidation loan is then paid off in monthly installments over an agreed-upon term.
A HELOC does not work this way. It is a revolving line of credit, meaning one can borrow as much or as little as they want within the terms of the loan. In this way, it is similar to a traditional line of credit or credit card.
However, a home equity line of credit is guaranteed by one’s house. Failure to make the necessary payments on a HELOC could result in the loss of one’s home.
Determining how much credit one has access to through the equity in their home is simple.
- Calculate The Amount of Equity One Has Access To: As outlined above, the amount of available equity in one’s home is equal to the current appraisal value less than the outstanding balance on the mortgage.
- Calculate LTV Ratio: The loan-to-value (LTV) ratio is a risk assessment measure that lenders examine prior to extending a home equity line of credit. The higher the ratio the more the loan is likely to cost the borrower.
Calculating LTV is as follows:
(LTV Ratio = Mortgage Balance / Appraisal Value) * 100
Continuing with the same example, a mortgage balance of $220,000 on a home appraised at $500,000 would result in a 44% LTV ratio.
- Determine If PMI Is Required: Lenders consider a HELOC with an LTV ratio of 80% or higher to be a high-risk loan. As a result, anyone looking to take out a home equity line of credit with an LTV ratio of 80% or above will likely need to purchase Private Mortgage Insurance (PMI).
PMI offers protection to the lender should the homeowner default on their primary mortgage. If the primary mortgage is defaulted on, the initial mortgage lender will foreclose on the property. Should this happen, the home equity lender will have no asset to take possession of and they will have no way to collect on their loan.
- Apply To An Accredited Lender: Shop around to see if different lenders offer better rates. Once a lender has been identified, a loan agreement is drawn up, and once approved, the homeowner has access to a HELOC.
Is It Worth It?
- Low-Interest Rates: Interest rates for home equity lines are significantly lower than the rates on credit cards. HELOCs allow individuals to consolidate numerous high-interest debts into a single low-interest debt.
- Flexibility: Unlike other lines of credit, there is no fixed term attached to the home equity line. As long as the minimum monthly payments are made the principal balance can be paid back whenever the borrower desires.
- Minimal Usage Fees: Most lenders do not charge fees to draw from a home equity line. Those that do usually only charge a small fee.
- Lack Of Stability: Traditional consolidation loans do not have fluctuating interest rates. HELOCs are typically variable-rate, meaning one’s monthly payments could increase due to economic conditions.
- Risk Of ‘Underwater’ Loan: If the value of one’s home drops below the initial mortgage value, in what’s known as an underwater loan, homeowners are required to pay the balance of the mortgage if they decide to sell their house. This can be a particularly difficult situation if one also has a home equity line of credit on top of their remaining mortgage balance.
- Foreclosure Possibility: If a borrower fails to repay the HELOC, they may have their home repossessed by the lender.
What About My Credit Score?
How a HELOC affects one’s credit score depends largely upon one’s debt-to-credit ratio. This metric measures how much of one’s available credit has been used. For example, if an individual's total available credit is $300,000 and they have used $150,000 of it, their debt-to-credit ratio is 50%.
A home equity line may initially improve one’s credit score because it will lower their debt-to-income ratio. However, as the individual begins to draw from the home equity line their debt-to-income ratio will increase, thus lowering their credit score.
One Last Thing To Remember About Paying Off Debt Using Home Equity
Using home equity to pay off debts should be a last resort. For most people, their home is their most valuable asset and any loan that requires their home as collateral should be avoided whenever possible.
Unsecured debt options, such as consolidation loans, balance transfers, personal lines of credit, and debt settlement, should all be considered before a HELOC.
A home equity line of credit can be a viable debt consolidation strategy for anyone seeking to consolidate a large amount of high-interest debt. Depending on the borrower, the interest rates on HELOCs are usually lower than other types of loans and they offer convenient revolving access to credit.
This said, borrowing against one’s home should not be taken lightly. Failure to make payments, or a large downturn in the housing market, could result in the borrower losing their home or holding an underwater loan.