If you have a lot of debt spread out over multiple credit cards and loans, you may be considering a debt consolidation loan. Any loan that you take out to pay off other debts and winnow down to one payment is considered a debt consolidation loan. Homeowners with equity in their houses can try to obtain a home equity installment loan for debt consolidation.
TL;DR (Too Long; Didn't Read)
A home equity installment loan is typically a good option if you're considering a debt consolidation loan because it's secured by your home and will have favorable terms.
The Credit Card Debt Problem
Credit card debt is on the rise in the United States. At the end of 2018, the total credit card debt reached $870 billion, and as of March 2019, 5 percent of all American credit cards were at least 90 days past due. Credit card debt can cause a cycle of worsening financial problems because you may come to rely upon credit cards to pay your living expenses as the monthly payments take up too much of your net income.
Other Problematic Debts
Credit cards aren't the only debt issue plaguing U.S. residents. Student loans are also a major headache. At the end of 2018, over 44 million Americans had amassed more than $1.56 trillion in student loan debt.
Debt consolidation loans are one option people choose to make heavy debt loads manageable.
Debt Consolidation Loans
A debt consolidation loan is a loan you take out to pay off other debts including personal loans, student loans and credit cards. A debt consolidation loan may be attractive if you have multiple creditors. For example, if you have five credit cards with balances that add up to $15,000, you may obtain a debt consolidation loan to pay all of them off. You'll then only have one monthly payment: the payment to repay the consolidation loan.
A debt consolidation loan may also offer a better interest rate. If you have two private student loans, for instance, one paid at 7 percent interest and one paid at 5 percent interest, and you're offered a debt consolidation loan with an interest rate of 4 percent, consolidation might make sense.
Some people want a debt consolidation loan simply to make things more streamlined. One payment is better than five, they might think. Still, you should take a look at the whole picture with respect to monthly payment, interest rate and number of months or years for repayment. The terms of your loan will depend upon your creditworthiness, but they will also depend upon whether your loan is secured or unsecured.
Secured Loans vs. Unsecured Loans
A debt consolidation loan may be secured or unsecured. Unsecured loans are loans that aren't backed by collateral. Credit cards are a type of unsecured debt. Unsecured loans typically have higher interest rates than secured loans because the lender has more risk to cover.
A secured loan is a loan for which you offer property as collateral. The lender receives a lien on the property, and if you don't pay the debt, the lender can sell the collateral to pay the loan. Car loans and home mortgages are the most common types of secured debt for consumers.
What Is a Home Equity Loan?
A home equity loan is a type of loan available to people that own houses. If your house is fully paid for, or if you do have a mortgage but your balance is less than the value of your home, you can apply for a home equity loan.
The bank will appraise your house and decide how much to loan you based upon how much equity you have. Hence, this type of loan is called a home equity loan. The lender then puts a mortgage on the property to secure the debt.
What Is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, is a type of home equity loan. All HELOCs are home equity loans, but not all home equity loans are HELOCs.
Unlike a standard home equity loan, however, with a HELOC, you don't get all the money in one lump sum. Instead, the bank gives you a credit limit, much like a credit card. You can then draw on the line of credit as you need it, up to the limit. So if the bank gives you a HELOC for $100,000, you can write checks or take money from the HELOC up to $100,000, but you don't need to use it all.
Home Equity Loans for Debt Consolidation
Home equity loan rates are often far lower than unsecured debt consolidation loans because the lenders have less risk when they can get a mortgage lien. The lower interest rate means lower payments, which gives these types of loans added benefits over unsecured loans. Home equity loans can also be used to consolidate any kinds of debts including credit card debt and student loan debt.
Downsides of Debt Consolidation
Although a home equity loan or HELOC are good ways to consolidate debts, any decision to take out a debt consolidation loan should be made carefully. Although the idea of having one payment instead of many is appealing, if you're not getting a better interest rate, you're not saving any money.
If you do get a better interest rate, take a look at the term of the repayment on the new loan. For instance, if the new loan's interest rate is 2 percent lower than your lowest credit card rate, but you opt for repayment over 20 years, you're likely to pay more interest on the new loan and thus pay more in total.
Downsides to Obtaining a Home Equity Loan
If you do own a home and are considering using a home equity loan for debt consolidation, keep in mind that the loan will eat up the equity in your house. If you own a home that's worth $200,000 and you have a first mortgage with a balance of $110,000, your house has $90,000 in equity. If you sold your house, you'd have plenty of money to cover closing costs and have some left for a down payment on a new house.
If you take out a home equity loan and borrow up to the full amount of the equity, your house will be fully encumbered. Using the example above, if you borrow $90,000 from a lender and give the lender a mortgage on the house, your total mortgage debt is $200,000, which is the value of your home. Your house has no equity, and if you had to sell, you would barely get enough to pay off the two mortgages.
In that scenario, you would have to come up with the money to pay any outstanding property taxes, water, sewer and other closing costs from your own pocket, and you would have nothing left over to buy a new house.
Mitigating the Problems of a Home Equity Loan
If you do really need that home equity loan, you can ease the pain of losing your home's equity by not borrowing up to the full limit. Instead of borrowing $90,000 on your $90,000 in equity, borrow only as much as you need, and leave some of the equity intact.
If you get extra money, pay the loan down faster; residential mortgage loans often do not have prepayment penalties (but you should check your loan documents to be sure because certain types of loans are allowed to have them).
- Bankrate: Home Equity Line of Credit (HELOC) vs. Home Equity Loan
- Business Insider: Home Equity Loan vs HELOC: Here's How to Decide
- Experian: How to Get a Debt Consolidation Loan with Bad Credit
- Credit Karma: Debt Consolidation With a Personal Loan: Pros and Cons
- Lexington Law: 2019 Average Credit Card Debt Statistics in the U.S.
- Forbes: 50% Of Americans Have Maxed Out Credit Cards, Here's How To Dig Yourself Out Of Credit Card Debt
- American Banker: What’s Behind the Rise in Credit Card Delinquencies
- Forbes: Student Loan Debt Statistics In 2019: A $1.5 Trillion Crisis
- Nolo: When Are Prepayment Penalties Allowed in New Mortgages?
Rebecca K. McDowell is an attorney focusing on creditor and debtor law. She has a B.A. in English and a J.D.