Pros and Cons of Consolidating Debt with a Home Equity Loan

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Thinking of consolidating your debt to help simplify payments or get a better rate? If you're a homeowner, one potential option is to use the equity in your home to pay off those unsecured debts.

A home equity loan, also known as a second mortgage, allows homeowners to borrow money by using the equity in their home as collateral. Equity is the difference between the home's current market value and the outstanding balance on the mortgage.

If you're struggling with debt but have a good amount of equity in your home, it may be a viable option. But is it a good idea for you? Here are some things to consider. 

Pros of consolidating debt with a home equity loan

Fewer monthly payments

By paying off your unsecured debts with a home equity loan, you’ll have fewer debts and debt payments to manage each month. This is one of the key features of most debt consolidation options: multiple debts and payments rolled into a single payment.

If one of the issues you're experiencing right now is that you're juggling more payments than you can handle, then this is one way to address that.

Fixed end date

If you’re only paying the minimum due on a large credit card debt, you could literally be paying for decades. Most loans usually have a clearly defined payment schedule, which spells out what you’ll pay, when it’s due, how much will go toward the principal, and when you’ll have the whole thing paid off.

Credit cards, by contrast, are a little more open-ended. You can make new charges (adding to the balance) and interest charges are added every month that you carry a balance.

If you need a little more structure and don't want to be tempted to keep adding to your debt, a home equity loan could work.

Lower interest rate

Loans and credit products are all about risk and reward for lenders. The higher the risk, they more they need to increase interest rates and fees to hedge their bets. Using an unsecured personal loan to repay debt may be more costly because there's nothing securing the debt for the lender.

A home equity loan, by contrast, leverages the equity in your home. That decreases the risk for the lender, because if something happens and you don't repay your loan, they may be entitled to seize your home and sell it to recoup the loan amount (more on that in the cons section).

While that's riskier for you, it's less risky for the lender, which often leads to better rates and lower interest charges as compared to an unsecured personal loan. 

Interest deductions

Moving your debt to a home equity loan could save you some money at tax time. That’s because you may qualify for a mortgage interest deduction, which would allow you to claim a reduced income based on the amount of interest paid on your mortgage (and home equity loan).

Cons of consolidating debt with a home equity loan

Best credit gets the best terms

If you’ve already missed a few payments and your credit score has suffered as a result, you may find it hard to qualify for loans with low interest rates and other helpful terms, even if you’re using your home as collateral.

If the terms of the loan aren't more favorable than your current terms, the loan may not help as much as you'd like.

Your home is on the line

As we discussed already, a home equity loan is secured by your home and you should always be careful using your home as collateral for a loan. If you default on a home equity loan you run the risk of facing a foreclosure.

That's a big deal. If the debt you're dealing with is primarily unsecured credit card debt, it's typically not a good idea to risk your home in order to pay that off. Keep in mind, if you default on your cards you may be sued by your creditors, but the worst outcome is typically a wage garnishment to repay your debts. That's much more preferrable than losing your house.

Less flexibility

Should your situation deteriorate and you struggle to make any kind of debt payments, you may find yourself considering bankruptcy. Bankruptcy is a perfectly acceptable option, but your options may be somewhat limited if your debts have been consolidated into a home equity loan or mortgage. You may not be able to discharge your debts without losing your home in the process. Be sure to consult with a qualified attorney if you’re considering bankruptcy.

Closing fees

Most loans include a variety of fees, as a result home equity loan or a mortgage refinance may have the most upfront costs of any consolidation option. Keep in mind the costs of taking out a loan in the first place.

Weighing your debt repayment options? Try MMI's free online financial analysis tool. We'll review your debts, income, and expenses, show your best available options and help you pick the path that works best for you.

Tagged in Debt consolidation, Debt strategies, Loans

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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