When faced with multiple payments, higher rates and a growing debt burden, many consumers look for a debt consolidation loan. A debt consolidation loan is a financing program that replaces multiple credit accounts with one consolidated loan. Instead of ten credit card accounts with ten payments, the borrower will have one loan with one monthly payment – preferably with a lower overall payment.
Debt consolidation loans can come in many forms, but there’s also a source for a consolidation loan not often recognized at first: home equity.
A home equity loan is a type of secured financing issued by a lender against the equity in a borrower’s home. Such loans are often in a subordinate, or secondary lien, position behind an existing first mortgage loan. For example, a home is valued at $300,000 and has a $200,000 first mortgage balance, that would leave $100,000 available in equity.
Home equity loans are partially based upon the combined loan to value, or CLTV. Most equity loans are issued up to 90 percent of the CLTV. In this example, 90 percent of the value is $270,000. As the first mortgage balance is $100,000 that leaves up to $70,000 available for a home equity loan. Qualified homeowners can then take out a home equity loan for part or all of that amount, depending on eligibility. Another option is to take out a home equity line of credit (HELOC), which is similar to a home equity loan – but the HELOC provides a revolving account check book instead of one lump sum check.
Home equity loans and credit lines offer tremendous advantages. But consumers must carefully review all the facts when considering a home equity loan to consolidate outstanding debt?
The first benefit is the lower interest rate available on most home equity loans. Because home equity loans are secured by real estate, they typically result in lower risk (relatively speaking) for the lender. Consequently, home equity loan rates can be found in the four percent range today, dramatically lower than credit card rates, which can hit 28 percent or higher, depending upon the credit card type.
Another benefit involves income tax considerations. An equity loan has mortgage interest and mortgage interest may be tax deductible for some taxpayers that itemize their deductions. When considering tax implications of any loan, it’s important to discuss the tax benefits with a tax professional before any decision should be made.
On the other hand, when a borrower takes out a home equity loan it can affect the ability to resell the house in the future if needed. For instance, using the above example, if the homeowner took out a $70,000 loan and tried to sell the home there may not be enough equity in the home allowing the owner to sell. This is particularly troubling if home values begin to drop or the owner needs to sell quickly to avoid a foreclosure.
The biggest problem with using home equity loans or home equity lines of credit (HELOCs) for debt consolidation, however, is that it converts unsecured debt into secured debt. This step typically results in greater risk exposure for the borrower, because of the nature of secured and unsecured debt.
To put it another way… if a borrower defaults on an unsecured debt, the unsecured loan lender can initiate collection attempts. But aside from the negative entries in the borrower’s credit report, the unsecured lender has limited remedies for getting money from the borrower.
The situation is dramatically more serious with secured loans, like car loans and mortgage financing. If a borrower defaults on a car loan, for example, the lender can repossess the automobile securing the loan, in order to pay off the loan balance. Similarly, homeowners who default on a mortgage loan face the prospect of foreclosure and home loss. And a home equity loan or line of credit is a mortgage loan.
So defaulting on a home equity loan or HELOC can result in foreclosure – a greater risk for the borrower than defaulting on unsecured credit card debts.
Using a home equity loan and its many benefits should be considered when evaluating loan consolidation options. However, homeowners need to fully understand the costs and risks involved with using their homes’ equity to consolidate debt. And homeowners who do take this step must ensure that they don’t fall into the same debt traps as they did with their credit cards and personal loan debts.