When burdened with credit card debt or medical bills that are piling up, finding a way out of the mess is no easy task. A home equity loan could be a way out of the mess.
If you’ve built up a decent amount of equity in your home, borrowing against it may seem like the obvious choice but there are some pros and cons you’ll want to consider first with a home equity loan:
Pro #1: You can get out of debt faster
It’s difficult to chip away at your debt when it seems like the money you pay is going mostly toward the interest each month. Paying more than just the minimums means you’re knocking down the principal faster but if you’re juggling multiple cards, that can be difficult to do.
Using a home equity loan or line of credit to pay the debts off all at once means you’ll have just one payment each month to focus on.
Since the interest rate is usually much lower with a home equity loan, more of your monthly payment is being applied to the principal. The less you’re paying in interest, the less time it’ll take for you to clear the debt. Not only that, but you could be saving thousands of dollars along the way.
Pro #2: It may be easier to get approved
Getting a traditional loan from a bank has gotten a lot tougher as lenders have tightened their restrictions in the wake of the recent recession.
When you’re shopping for a consolidation loan, your income, assets and credit score are all going to come under much closer scrutiny. If your income is sporadic because you’re self-employed or you’ve taken a pay cut recently, getting approved can be an uphill climb.
Since a home equity loan is secured by your property, your lender may be willing to extend a little more flexibility during the application process. If you’ve got a solid credit score, you’ve been at your job for awhile and consolidating would lower your monthly debt payments, the bank may allow for some leeway if your income has taken a dip since you originally bought your home.
Pro #3: Home equity loan tax break
One of the nice things about owning a home is that the interest you pay toward your mortgage, including home equity loans, is generally tax deductible. Claiming the deduction can reduce your tax liability, which can be a major boon if you normally end up owing Uncle Sam. No such deduction is available for the interest paid on credit cards.
There are a couple of rules to keep in mind if you’re planning on deducting mortgage interest. First, the amount of interest you can deduct on a home equity loan is limited. For 2014, the deduction is only available for the interest paid on the first $100,000 of equity you borrow.
Second, the loan must be secured by the home and you’ll have to itemize on Schedule A. If your itemized deductions don’t exceed the standard deduction, you won’t be able to write off the interest.
Con #1: Higher degree of risk
Credit cards and medical bills are unsecured debts, which means they’re not tied to any sort of collateral. If you end up defaulting on an unsecured debt, your creditors can take a number of collection actions against you but they generally can’t lay claim to any of your property.
When you roll these kinds of debts into a home equity loan, you’re effectively making them secured debts which means the stakes are much higher if you don’t pay up.
Before you sign on the dotted line for a home equity loan, take a realistic look at your finances to make sure you could cover the payments if something unexpected occurred.
If you don’t have a lot of cash reserves or your job situation is unstable, you may be better off delaying consolidation. Otherwise, you could find yourself facing down a foreclosure proceeding if you end up falling behind on the loan payments.
Con #2: You may be stuck if you decide to sell
While home values seem to be on the rise for the most part, there’s always the chance that they could drop again. If that happens, you may end up underwater on the home, which can be a major barrier if you decide to sell.
Prospective homebuyers typically aren’t going to be interested in taking on a mortgage that exceeds the property’s appraisal value and even if they are, getting a bank to approve such a deal is a long shot.
The federal government offers mortgage relief programs to help out homeowners who can’t sell their homes or at least refinance because they’re upside down, but getting approved means jumping through some serious hoops. The alternative is to either suck it up and keep making the payments or try to arrange for a short sale.
A short sale means the bank agrees to let you sell the home for less than what you owe. Your credit will certainly take a hit and you may end up owing taxes on the amount of the loan that’s forgiven. These are risks that you need to be fully aware of before you decide to take on a home equity loan.
Alternatives to a home equity loan
A home equity loan isn’t the only way to get rid of credit card debt. Contacting your creditors and attempting to negotiate a lower rate can make a big difference in how much you have to pay.
If you’re in a situation where debt collectors are calling you on a daily basis or you’re just feeling completely overwhelmed, talking to a non-profit credit counseling agency may be the answer.
The solution may be as simple as looking for ways to cut back on your spending so you have more cash to throw at the debt each month. Whichever route you choose, it’s in your best interest to weigh all of the options carefully to minimize the potential downsides.