Should you use your home equity for debt consolidation? This is a question that homeowners with credit card debt, car loans, and student loans often ask.
Home equity is the difference between your home’s value and the debt owed on the home. For example, if your home is worth $250,000 and your mortgage balance is $180,000, you have $70,000 in equity. If approved by a bank, it is possible to take out an additional loan (second mortgage) or a line of credit based on that equity. Or you can refinance your first mortgage, but take on a greater amount.
Some use their home equity to consolidate their debts. They do this because the interest on a home mortgage or line of credit is often lower than the interest rate associated with their credit card debt or other loans. They think that a debt consolidation is a way to pay less interest on their debts. Why pay 15% on a credit card debt and 9% on a car loan when they can wrap it into a mortgage and pay 5% on it all?
And at first glance, you may find yourself nodding your head in agreement. Makes sense, right? Who wouldn’t want to pay 5% instead of 15% or 9%?
But it is not a no-brainer. In fact, the logic above causes you to miss the potential negative consequences such a move makes. So before you remove the equity in your home, let me provide the downside of using your home equity for debt consolidation.
- Your debt is stretched out over a longer period of time. Loans attached to houses tend to have longer terms—10, 15, 30-years. You could end up paying for that couch you put on your credit card for 30 years! That’s insane.
- You could lose your house. What happens if you no longer pay your credit card bills? You go to collections. What happens if you no longer pay your mortgage? You can lose your house. Now, you should pay your bills, whether they are credit card bills or mortgage payments. A debt consolidation using your home equity will increase your mortgage payment. If you are already struggling financially, do not put yourself in a place where you can no longer pay your mortgage. While I do not want you to default on any owed debt, I would rather you go to collections and keep your home than to lose your house.
- You could become upside down on your home. In the financial world, “upside down” means that the amount you owe on something is greater than the value of that thing. For example, if you owe $260,000 on a house that’s worth $250,000, you are upside down (by $10,000) on that house. This can happen if the value of the house experiences a decrease. Placing more debt on your house can put you at risk for being upside down.
- The deeper problem remains. Consolidating debt using home equity regularly does not solve the greater problem—spending more than you make. It tends to act as a temporary cover up. Unless the credit cards are destroyed, individuals continue their bad financial habits and find themselves with credit card debt once again. But this time, they have a larger, more expensive mortgage to pay. And the risk of losing their house increases.
By the way, you cannot deduct the mortgage interest on the portion used to consolidate your debt. The 2018 tax reform eliminated that possibility.
Personally, I do not recommend using your home equity to consolidate debt. Certainly, the lower interest rate is enticing, but the risks are significant. Pay down your debts aggressively using the debt snowball method. Avoid using your home equity. And most importantly, develop sound financial habits so that you can give generously, save wisely, and live appropriately.