How Home Equity May Help You Escape Debt

If you are trying to work out how to eliminate debt, one possible answer may already be tied up in your house.

Using your home equity — the gap between your home’s value and what you still owe on the mortgage — can be a way to consolidate debt and potentially cut interest costs substantially.

U.S. homeowners are currently holding a record amount of equity, with the average mortgage holder sitting on about $310,000, according to real estate data firm Cotality. At the same time, Americans are carrying costly credit card balances, with the typical card balance above $6,600, according to TransUnion.

That combination has helped revive interest in home equity products, particularly home equity lines of credit, or HELOCs. Often called second mortgages, these loans let you borrow up to a set limit, spend what you need, and then repay according to terms set with the lender.

Even so, surveys show that using home equity to pay off higher-interest debt is not a widely embraced approach. In a recent Achieve and Money.com survey, fewer than one in four respondents said they were comfortable with the idea. Approval rose to 33% among people who said they had “far more debt than is manageable,” but that still trailed other consolidation choices such as personal loans.

Here is a closer look at the advantages and drawbacks of using a HELOC for debt consolidation, and how homeowners can tap their equity to pay down what they owe.

The advantages and risks of using a HELOC to reduce debt

For borrowers carrying a large amount of expensive debt, especially credit card balances, a HELOC can offer a lower rate. Current HELOC rates start around 6%, well below the average credit card annual percentage rate, which is above 22%.

HELOCs can also be more flexible than many other loans because they usually do not provide a one-time lump sum. Instead, they work as revolving credit, allowing you to draw funds as needed from the approved limit and only pay interest on what you actually use.

There is additional flexibility in how the money is spent, since HELOCs generally do not restrict the purpose of the funds. A home equity loan, which is related but different, is paid out all at once, and interest starts accruing on the full amount immediately.

In some cases, HELOC interest may also be tax-deductible if the money is used for a home improvement project. That does not help someone who only wants to use the funds to pay down debt, but many borrowers draw on their credit line more than once during the draw period, so it may be possible to borrow first for debt repayment and later for a home project.

There are downsides as well.

“You are borrowing against your home equity and you’re putting your house up as collateral, so in the worst case scenario, the lender essentially has a lien on your house,” says Glenn Downing, founder and principal of investment advisory firm CameronDowning. “You’re putting your family’s residence on the hook.”

If your home’s value declines, you could also wind up owing more than the property is worth.

Some lenders offer fixed-rate HELOCs, which can be attractive for debt consolidation because they make payments more predictable. But in general, HELOCs have variable rates, so you may not be able to lock in a low fixed payment and could see your costs rise if interest rates increase.

HELOCs can also encourage larger borrowing than you may need. In many cases, you can access up to 85% of your home’s value, minus the mortgage balance. For example, a home worth $350,000 with $150,000 still owed could potentially support a credit line of up to $147,500 — far more than many people would need to erase high-interest debt. Mike Miller, a financial advisor at Integra Shield Financial Group, says he always asks clients interested in HELOCs why they want the extra cash.

“There may be some underlying issue there related to spending,” Miller says.

How to use a HELOC to pay off debt

Using a HELOC or home equity loan for consolidation means borrowing from your home to pay off more expensive debt, such as credit cards.

When you apply for a HELOC, the lender will decide how much of your equity you can borrow against. Be prepared for possible upfront costs, including application or origination fees, though some lenders may waive them or build them into the line of credit.

Once the loan is in place, you can begin borrowing during the draw period, which typically lasts five to 10 years. Depending on the terms, you may need to take an initial draw or meet a minimum borrowing amount each time you use the line. After receiving the funds, you can begin paying down your higher-cost debts.

Because HELOCs let you borrow as needed, they can be useful if you want the option to consolidate now and still have access to credit later. Miller says he sometimes recommends that clients open a HELOC even if they do not plan to use the funds right away, depending on their circumstances.

“It’s kind of like an emergency fund,” he adds.

If your only goal is to wipe out credit card debt in one transaction, a home equity loan may be the better fit. That type of loan lets you borrow the exact amount you need and then start repaying the lower-rate balance immediately.

Repayment terms on HELOCs can vary. Some allow interest-only payments during the draw period, while others require both principal and interest from the outset. Since the main purpose of a HELOC in this situation is to make debt repayment more manageable, it is wise to choose a line of credit with a structured fully amortizing schedule or to pay more than the minimum so your payments do not become unmanageable later on.