Are you swamped with high interest debt and looking for a solution? The airwaves are filled with ads for debt consolidation, but do you really need someone to do it for you? Why not do your own legwork and roll your debts into one low(er) interest loan?
One option for consolidating your debt is rolling it into a HELOC. But first… You might have some questions.
What is a HELOC? Is consolidating debt with a HELOC a financially sound decision? What problems might arise if you use your HELOC to reduce your debt?
What is a HELOC?
The term HELOC is shorthand for “home equity line of credit.” Home equity is defined as the difference between what your house is worth and what you owe on the mortgage. This home equity line of credit essentially let you borrow money using the equity in your house as collateral.
Lenders typically calculate the line of credit based on a percentage of your home’s appraised value. For example, if you have a house that is appraised at $200, 000 and your principle is $135, 000, he lender may calculate your home equity line as:
$200, 000 * .80 (it varies among lenders) = $160, 000
$160, 000 – $135, 000 = $25, 000 HELOC limit
The percentage of your home’s appraised value depends on the lender, but it’s generally 75-80%. With houses appraising for much less than they used to in some areas, many homeowners have had their HELOC reduced or closed.
Why you should use a HELOC
The big plus with using your home equity line of credit to consolidate your debt is that you’ll almost certainly reduce the amount of interest that you’re paying. Since it’s a secured loan, your HELOC will typically will have a much lower interest rate than your credit cards.
If you’d like to play around with just how much you can save, I highly recommend the online calculator over at Dinky Town.
Another good reason to use a HELOC is that, assuming you itemize you tax deductions, the interest on your HELOC is tax deductible. Thus, you’re not only paying much less in interest, but you’re also catching a tax break, thereby reducing the cost further.
Why you shouldn’t use a HELOC
The other side of the coin when using a HELOC to consolidate debt is that you’re taking unsecured debt (credit cards) and tying them to your home. This can be a risky bet – what happens if you lose your job and can’t pay your HELOC? You risk losing your house, that’s what.
Also, getting a HELOC isn’t necessarily cheap. There are several possible fees associated with it that add to the total cost. Some of the fees you might face include:
- Appraisal fee
- Application fee
- Annual fees (some, not all lenders charge this)
Ultimately, you’ll have to weigh the costs of opening an account against simply using a debt snowball, or similar approach, to get out of debt.
It’s also worth noting that lenders have gotten much more strict when it comes to approving loans, so if you’re looking at getting one, be sure that you can qualify.
Another minor downside is that when you apply for a HELOC, they’ll do a hard credit inquiry which can hurt your credit score. It’s not much of a hit, but it’s worth keeping in mind.
Thoughts on using a HELOC for debt reduction
In my opinion, if you can get yourself out of debt in two years or less, I wouldn’t bother with a home equity line of credit. If you’re struggling with high interest rates, try negotiating with the credit card companies or look into doing a balance transfer to a card with lower interest.
Personally, I’m not a fan of converting unsecured debt (credits cards) to secured debt (HELOC). Yes, you can save money, but… With people getting laid off and paychecks being cut, your plans could fall through and you could lose your home.
There are other options besides using a HELOC if you’re looking to consolidate your debt. For example, you could try to get a personal loan through your bank or credit union, or you could consolidate your debt with a loan from Lending Club.
Have you ever used a HELOC to consolidate your debts? How did it work out for you? Would you do it again? Why or why not?