Living with less debt is a common goal among homeowners. But it’s not always a goal that’s easily attained. Having a mortgage automatically puts you in debt; however, financing a home is more like financing an investment. You’ll most likely build equity over time as the value of your home increases – sort of like having money in an interest-bearing account. But some homeowners with substantial debt (high credit card balances, medical bills or student loans) may be tempted to use that money to eliminate their other financial burdens.
What is a Home Equity Loan?
By using their home’s equity as collateral, homeowners take out a new loan to pay off other debts and expenses. However, not all lenders offer home equity loans, making them a bit tougher to find. Also, they’re a little bit harder to qualify for. Most home equity loans require good to excellent credit scores, as well as pretty strict loan-to-value ratios. Furthermore, even if you can find a home equity loan that you qualify for, it may not necessarily be the best option for your needs.
Pros and Cons of a Home Equity Loan
Using home equity loans to consolidate debt comes with a few pros and cons. On the upside, home equity loans can offer lower rates than unsecured loans. Also, the interest on the first $100,000 is tax-deductible, regardless of how it’s used. According to Bankrate, additional interest could be tax-deductible if the money is used for business expenses or some other allowable purpose.
On the downside, home equity loans can make put a debt-burdened homeowner in an even worse position should he or she fail to keep up with the payments. A home equity loan essentially acts as a second mortgage, putting a lien against the home and putting the owner at risk of losing it should things go south. Furthermore, a home equity loan could leave you owing more than you can get for your house later if values fall and you decide to sell. This is a particularly high risk for loans with high loan-to-value ratios, in which the borrower can draw up to 100 percent (or more) of the home’s equity.
Alternatives to the Home Equity Loan
- Request a rate decrease
To get a lower interest rate on a major credit card, believe it or not, sometimes all you need to do is ask. If you mention that you are trying to get out of debt and could use some help, the credit card company may be more inclined to agree to a reduction. Remember to be honest, be polite and don’t be afraid to do a little respectful haggling. Start out by asking if they can reduce your rate to zero percent for 12 months. They may come back with an offer of 4 or 5 percent. Or, they may offer a rate of 1 or 2 percent for six months. Regardless, any break they’re willing to give you would be better than what you currently have.
- Consider a cash-out refinance
A cash-out refinance loan allows the borrower to refinance his or her home for an amount higher than they currently owe on it. For example, if you owe $200,000 on your home, but it’s worth $300,000 – you could refinance the home for $240,000 (80 percent of the home’s value) and get the $40,000 difference in cash. That money can be used to pay off your other debts. This could be a great option for people who are paying a higher mortgage rate, as the cash-out refi may also be able to help them save on their monthly mortgage payment.
- Take the DIY approach
If you’ve got the discipline and the drive, and you’ve got enough income to put money toward your debt consistently, then you can very likely take charge of your debt and resolve your problems without having to take out a loan. One method is the “debt snowball.” Dave Ramsey popularized this method but several financial experts have touted its benefits.
Here’s how it works: First, list your debts in order from lowest balance to highest balance, not including your mortgage. Don’t worry about interest rates or terms unless you have more than one debt with the same balance. In that case, list the higher interest rate debt first.
Next, designate an amount of money you can realitically afford to put toward paying your debt each month. You can do this by adding up the minimum payments for each bill and evaluating how much extra you could afford to tack onto it. For example, say you have three credit card balances. From lowest to highest, their balances are…
Let’s say the minimum payments on each are $50, $60 and $75, respectively. Total, you would be paying $185 for your credit card debt every month. Now let’s say you could realistically afford to put an additional $50 toward paying your debt each month. That brings the total to $235.
Start paying off each balance beginning with the smallest. Make the minimum payment on all debts except the one with the lowest balance. For that debt, put the extra money toward it every month. Using the example above, that means you would start by paying off your credit card with the $800 balance first. But instead of making the $50 minimum payment, you would be putting the extra $50 toward it each month. If you do this, you will cut the payoff time for that card in half from 16 months to 8 months.
Here’s how the payments would break down each month:
- $100 toward the $800 card
- $60 toward the $1,000 card
- $75 toward the $2,000 card
Once you get one balance paid off, simply repeat the process for each additional debt. Do not alter the total amount used to pay debts each month. Simply put any extra toward the balance you’re currently working on. Using our example, after you’ve paid off the $800 balance, you will now owe a total of $135 for your remaining debts each month. However, since you will still be designating $235 for debt payments, you will now have an extra $100 to put toward your next-highest debt. Now you’d be paying $160 on the $1,000 debt each month instead of $60.
- $160 toward the $1,000 card
- $75 toward the $2,000 card
Once you get down to your final balance, you’ll be putting all the money you designated for monthly debt bills toward one debt. In our example, the $2,000 balance would get the full $235 each month instead of only $75.
Of course, using this method, it will still take time before all debts are paid down. But the benefit is that you’ll see results happen sooner and that can provide tremendous psychological benefits to help you stay motivated.
You might also like:
- Cash-Out Refinancing Gaining Popularity as Homeowners Gain Equity
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