Debt Consolidation via Home Equity Loans: What to Know

Don’t be Left Homeless Due to the Home Equity Loan Trap!

A home is probably the largest single purchase that you will ever make in your lifetime. So it makes sense why many homeowners would look to their property ownership as a way to help them get out of debt. After all, your home is the most expensive asset you own, which makes it the best collateral you have.

Now you can consolidate your debt via a home equity loan quite simply, and believe me lenders will offer it as the first solution if you own a home, or own a good portion of your home, because you’re offering up a huge piece of collateral – your house! The amount that you can take out in a home equity loan will be determined by the current market value of your home – subtract what you owe on your mortgage. So take for example a $200,000 home that you’ve paid $100,000 off on the mortgage. That means you have $100,000 worth of equity in your home. Mind you most lenders will only let you borrow 80% of that amount, so according to my example above you would have $80,000 worth of home equity you could borrow using your home as collateral.

However before you decide to use the equity of your home to pay off your credit card debt, perhaps some advice from a financial advisor such as personal finance guru Dave Ramsey counsels people against using a home equity loan to pay off your debt on his nationally-acclaimed self-named radio program, in his best-selling books and his Debt-free Friday radio program. In an article from Yahoo Finance, called The Dangers of Home Equity Loans, Ramsey calls home equity loans the “problem child in the economy.” He says that in his eyes the negatives far outweigh the positives of home equity loans, and that the biggest reason he advises against using them to get out of debt is because people don’t have a clue when it comes to the terms of their home equity loans. In addition home equity loans are almost always used to fund things – like debt and home repairs - that individuals should have saved up for in the first place.

I would tend to agree with Ramsey on this one. By putting the biggest asset (your home) on the chopping block in order to pay off outstanding debt, the risk of finding yourself homeless is very high.

If you speak to your financial institution about using a home equity loan to consolidate debt, you’ll likely get another story. They’ll offer you tax advantages, which makes sense because you’re putting such a valuable asset up as the collateral. If your financial institution recommends a home equity loan they will push the following pros:

No closing costs – Sure a home equity loan is based on the equity (worth) of your property, but there are no closing costs associated with it as there is with a mortgage.

Lengthy loan terms – A home equity loan term (length) typically ranges between 5 and 20 years. They are based on mortgages after all and some people will borrow anywhere from $10,000 to $70,000 to pay off debt over the next 20 years.

Income tax breaks – Generally you can borrow a maximum of $100,000 on your home’s equity and deduct the interest come tax time. This is an attractive bonus; however mortgages vary so always consult with an accountant before you go this route for this reason.

Lower interest rates – Come on, you’re putting your home up as collateral – how secure is that? Because home equity is worth so much – and you risk losing your home if you don’t pay it back – you will receive a lower interest rate compared to traditional personal loans.

However remember that taking out a home equity loan puts your house at risk! If you can’t pay the loan back – you will lose your house! Plus depending on how large the home equity loan you take out is, it could actually cause your home to depreciate in value over the long-term. So your home may be worth less by the time you actually pay off your loan. Think about a home equity loan with a term of 30 years, and ask yourself what your home will be worth 30 years down the line. What’s worse is that the first home equity loan may be a difficult decision, but after you’ve done it once, it’s super easy to refinance again and again. The value of your home will depreciate drastically if you continue to refinance your home over and over again.

What’s even more tragic is that you can’t depend on lenders to offer up this information. They will just flash the pros of home equity loans in front of you and expect you to sign on the dotted line. However they will never volunteer the following cons:

Variable interest rates - which is a fancy term for unpredictable or adjustable mortgage interest rates are determined by an index. Many times variable rate mortgages are more attractive than fixed rate mortgages because the variable rate is lower when the agreement is made. However a variable rate can rise a great deal over the term of your home equity loan, which can drive you further and further into debt.

Balloon payments – at the end of your loan term can really cost you a fortune. This occurs with home equity loans that don’t amortize, which means that the borrower suddenly has to pay a lump sum on the remaining debt and interest on this amount at the end of the loan term.

Early repayment penalty – It seems ridiculous that lenders would penalize you for paying off a loan early, but when you due it cut into the interest they’re owed. Lenders like to draw loans out as long as possible to get their interest due – and plus in many cases when you can’t make payments. These penalties will trap you into paying off the loan and all the interest you owe.

Unnecessary extras – such as protection insurance on your loan will drive up your balance.

Reduction in home equity - When you use your house as collateral, you’re actually reducing the equity of your home. You purchased your home in the first place in order to build your personal equity right? So then why would you take out a loan on your home that will work against it’s worth and take you years to rebuild – maybe even well into your retirement. Even when it comes to investing the money into home improvements that you think will add to the value of your home, you’re often borrowing at a higher rate, so funding home improvements will end up costing you almost double the amount - compared to if you paid in cash. Also remember that even though having the next 20 year to pay off your debt sounds like the deal of a lifetime – you will be paying off items that you’re in debt for like your car, flat screen television and computer for the next 20 years – plus interest! Is it really worth it?

For further information:

The Federal Trade Commission offers a helpful article entitled Need a Loan?, to help customers weigh the pros cons of using your home as collateral.