How to Pay Off Debt with a Home Equity Loan

As Americans, our relationship with debt is complicated. Without a certain amount of debt, it can be challenging (or impossible) to grow your credit score, establish a credit history, and prove your creditworthiness to banks –– making you a potential liability to any would-be lender. Too much debt, on the other hand, and you’re an even greater risk. Many financial experts will agree the sweet spot between these two points is somewhere in the middle.¹ As for how you get there, well, that’s up to you. 

If you’re like most Americans, there’s a good chance finding this sweet spot will begin with paying down some of your debt, not acquiring more of it.² Fortunately, there is a near-infinite number of ways to get this debt under control. 

A home can be a place of refuge and the site of countless memories as well as a valuable asset and a powerful lever for achieving financial goals –– with home equity loans allowing you to free up the cash needed to eliminate personal debt. Explore the intricacies of home equity loans, the benefits and risks involved, and the steps you can take to use a home equity loan to pay off debt and regain financial control.

Understanding Home Equity Loans: A Comprehensive Overview

Before delving into the specifics of how to use a home equity loan to pay off debt, let's examine what a home equity loan –– and home equity –– is. At its core, a home equity loan (sometimes called a second mortgage) is a financial instrument that allows homeowners to tap into the home’s equity they've built up over time. This equity refers to the difference between the current market value of the home and the outstanding mortgage balance, accumulating as homeowners make monthly mortgage payments and the property appreciates in value. The more equity a homeowner has accrued, the more they’ll be able to access via a home equity loan. Assuming they meet the credit and income requirements, of course. (But more on that later.)  

The home equity loan amount is fixed, meaning the borrower receives the funds as a lump sum rather than in a series of installments or as needed over a draw period (as is the case with a home equity line of credit.) These funds can then be used for a variety of purposes. Some borrowers will use these funds to tackle costly home renovation projects or invest in business ventures, but one of the most compelling uses of a home equity loan is debt repayment through debt consolidation: a strategy that involves combining multiple high-interest debts into a single, more manageable loan, organizing one’s finances and potentially saving thousands in interest fees. 

Evaluating Your Debt Situation: How Much Home Equity Do You Need?

Before setting foot on the path of using a home equity loan for debt consolidation, you should first conduct a thorough evaluation of your current financial situation. This involves taking stock of all outstanding debts, such as credit card debt balances, student loan debt, and other obligations. Much of this information will be required to apply for a home equity loan, but keeping this info handy will also ensure you take out the right amount of home equity to accomplish your goals. 

Why should you ensure this figure is spot-on accurate? At the end of the day, taking out debt to pay off other debts is still debt. And if you’re trying to make strides toward a brighter financial future, limiting the amount of debt you take on will help you stay on track. Take out too large of a home equity loan, and you could soon discover that your home equity is working against you rather than with you. 

Benefits and Risks of Using Home Equity for Debt Consolidation

Organized finances, thousands of dollars saved in interest fees –– the prospect of using a home equity loan to pay off debt comes with a basket of benefits. Still, it's essential to weigh the pros and cons of a home equity loan (of which there are many). 

Pros of Debt Consolidation with a Home Equity Loan

• Lower Interest Rates: One of the primary benefits of using a home equity loan to consolidate debt is the potential for significantly lower interest rates when compared to credit cards or personal loans. While this interest may not seem like much on a month-to-month basis, scoring a single-digit rate can mean thousands saved over the life of the loan.

• One Monthly Payment: Depending on your debt situation, it’s possible that you may have multiple loans which each come with their own monthly payment. Debt consolidation using a home equity loan simplifies your financial life by combining multiple debts into a single monthly payment. So, instead of juggling various due dates and minimum payments, you have a unified payment schedule and one (ideally lower) rate.

• Faster Debt Repayment: With a lower interest rate, your monthly payment might stay the same, but more of this payment will go toward reducing the principal. This means you can get debt-free, sooner.  

• Improved Credit Score: This debt consolidation strategy is best when part of a long-term financial plan. In addition to reducing your financial exposure, eliminating high-interest debt –– while successfully managing a home equity loan –– can positively impact your credit score over time. 

Cons of Debt Consolidation with a Home Equity Loan

• Potentially Higher Total Debt: While interest rates on home equity loans are generally lower than other options, the loan term could end up being longer than your current debts. This could mean paying more in interest over the life of the loan, even with a lower interest rate.

• It Takes Discipline: It’s important to note that debt consolidation doesn't solve the root causes of debt –– it merely transfers the debt to a different loan. And to truly benefit from the consolidation process, you'll need to exercise financial discipline to spend effectively and avoid overuse.

• Closing Costs and Fees: As with any other loan, home equity loans carry their own fees and closing costs. These upfront expenses can eat into the potential savings from lower interest rates, particularly if the loan amount isn't substantial.

Considering the countless benefits and limitations of using a home equity loan to consolidate and eliminate debt, it’s important to consider all the variables before pursuing this option. If you’re planning on a short repayment horizon or concerned with your ability to utilize your home equity loan wisely, it might be worth considering an alternative. 

How to Qualify for a Home Equity Loan with Bad Credit

So, how long does it take to get a home equity loan and how do you get the best home equity loan rate? The process of using a home equity loan to pay off debt is not always smooth, especially if your credit history has a few bumps along the way. But while a strong credit score can speed up the qualification process (and maximize your odds of getting an ideal rate) those with bad credit need not lose hope –– lenders take several factors into account beyond just your credit score when assessing eligibility for a home equity loan.

For instance, lenders often consider your debt-to-income ratio, which is a reflection of your monthly debt obligations relative to your income. Steady income, too, can offset a less-than-ideal credit score. And of course, the amount of equity you've built up in your home will also play a key role in determining your loan eligibility. The more equity you have, the more likely you are to secure a loan, even with bad credit. And no matter how good your credit is, many lenders will insist that you own at least 15% of your home outright to secure a home equity loan.³

Nevertheless, if you have the time, patience, or ability to do so, it's wise to improve your credit score before applying for a home equity loan. Even a minor score increase can pay dividends, potentially leading to a better loan term and lower interest rate.

Creating a Solid Debt Repayment Plan with a Home Equity Loan

Accessing your home’s equity to consolidate debt is just the beginning –– the real work starts with crafting a comprehensive debt repayment plan that empowers you to regain financial control. Start by prioritizing your debts, listing all your outstanding obligations and their interest rates and amounts owed. With a clear understanding of your personal loan or debt landscape, you can make informed decisions on how to allocate the home equity loan funds.

Many sources say the key to debt repayment is tackling the highest-interest debts first.⁴ These are the debts that most quickly accrue interest, making them the most financially draining. By eliminating them with the funds from your home equity loan first, you can more effectively reduce smaller debts. This strategy can be especially helpful if your home equity loan cannot cover your total balance –– allowing you to stretch your dollars further. 

But even the best debt repayment plans can be undone without proper discipline. And once your debt repayment strategy is in place, it's crucial to stick to it. While the allure of having access to a large sum of money can sometimes lead to impulsive spending, remember that the loan is not a windfall but a financial tool to be used to accomplish your goals.

Harnessing Home Equity for Debt Freedom

In many ways, it seems that debt is as much a part of modern American life as a home is, and leveraging a home equity loan to manage this debt feels natural –– even almost poetic. But as we’ve clearly explained, paying off debt with a home equity loan presents significant risk, and may not be the right path to debt freedom for everyone. And should you recognize that a home equity loan is not right for you, know you have options. One of these options is Truehold’s sell and stay transaction. 

Through our sell and stay transaction, homeowners can free up their home equity (as with a home equity loan) and use the proceeds to eliminate pesky debt –– and enjoy the spoils of life while you continue to live in the home as a renter. We’ll take care of essential repairs, property tax, and property insurance.

To discover why more and more Americans are trusting Truehold to free up home equity and achieve freedom from debt, get in touch today. 

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Sources: 

1. Forbes. Is It Better to Save Or Pay Off Debt?  https://www.forbes.com/advisor/banking/saving-vs-paying-down-debt/ 

2. Debt.org. Demographics of Debt. https://www.debt.org/faqs/americans-in-debt/demographics/#:~:text=With%20average%20consumer%20debt%20in,Americans%20are%20feeling%20the%20pain. 

3. Bankrate. Requirements for a home equity loan or HELOC in 2023. https://www.bankrate.com/home-equity/requirements-to-borrow-from-home-equity/ 

4. Experian. What Debt Should I Pay Off First? https://www.experian.com/blogs/ask-experian/what-debts-should-i-pay-off-first/