Are you struggling with high-interest debts, such as credit cards or lines of credit, and looking for a way to pay them off faster? Two solutions you might have come across are taking out a home equity loan or filing a consumer proposal. Both offer a way to consolidate and manage your debts—but that’s where the similarities end.
Both home equity loans and consumer proposals have risks and benefits that need to be considered. However, which option is better will depend primarily on your financial health (such as your credit score) and the severity of your debt problems. This guide explores how debt relief options work to lessen your debt burden, and the key pros and cons to consider.
How to decide between a home equity loan and consumer proposal
Below is an overview of some of the key points to consider when deciding whether to use a home equity loan or a consumer proposal to deal with your debts.
| Choose a home equity loan if you | Choose a consumer proposal if you |
|---|---|
Qualify for a low interest rate and can access affordable borrowing based on your home equity. | Cannot qualify for a reasonable loan or are only approved at very high interest rates. |
Can comfortably handle the payment without stretching your monthly budget. | Need protection from creditors and want collection calls and legal action to stop. |
Want to protect your credit rating and avoid the impact of a formal insolvency filing. | Need a reduction in what you owe and full relief from interest charges. |
Prefer a longer repayment window and are comfortable paying the full balance over time. | Do not want your home at risk and refuse to pledge it as security for more borrowing. |
Value flexible use of funds and may want to use some of the money for other goals. | Can commit to a five year plan to clear your remaining unsecured debt through one proposal payment. |
What is a home equity loan?
A home equity loan is a secured loan that allows you to borrow money using the equity in your home as collateral. Equity is simply the difference between your home’s value and the outstanding balance of your mortgage. For example, if your property is valued at $600,000 and your remaining mortgage is $350,000, you have $250,000 in equity.
In Canada, you can use this home equity to obtain a loan up to 80% of your home’s appraised value, minus what you owe on your mortgage. So using the above example, you may qualify to borrow up to $130,000 (($600,000 x 80%) – $350,000).
Since your property serves as security for the borrowed funds, a home equity loan is sometimes referred to as a second mortgage. It also shares similarities with a home equity line of credit (HELOC), which also allows you to tap into your home equity to pay off debt. Learn more about how HELOCs work and the latest regulations surrounding them in Canada.
How does a home equity loan work?
When you take out a home equity loan, you receive a lump sum of money from your lender. You must repay this amount in fixed installments (with interest) over a set period, often 5 to 30 years. A monthly payment frequency is the most common, though most lenders offer other options, such as biweekly. The interest rate remains fixed for the entire loan term, so your payments stay consistent.
How a home equity loan helps with debt repayment
So why exactly would you take out another loan backed by their home equity when they’re already drowning in debt? The reason is simple: to save money and pay off these debts faster.
You can use the money from a home equity loan to consolidate expensive debts, such as those charging double-digit interest rates. Because your property secures the loan, the interest rate is typically much lower than what you’d pay on credit cards, lines of credit, and payday loans.
For example, instead of juggling multiple credit cards with an average interest rate of 22%, you can replace them with a single loan at a lower interest rate, such as 6% or 8%. That’s a huge difference that can reduce your interest costs and shrink your monthly payments.
Pros of using a home equity loan to pay off debt
A home equity loan offers significant advantages if you’re looking to tackle expensive debts.
High borrowing capacity
Home equity loans can provide you with access to more money than other types of loans. If you’ve built up significant home equity, you could borrow enough to eliminate multiple unsecured debts in one fell swoop.
Lower interest rate
Because your house secures a home equity loan, it poses much less risk to lenders. As a result, they’ll be more willing to charge you a lower interest rate compared to unsecured debts like credit cards or traditional lines of credit. This low-interest feature can save you thousands of dollars over the loan term.
Fixed monthly payments
Home equity loans tend to come with fixed interest rates and a set repayment schedule, meaning the amount you pay each month will never change. This stability means you’ll be able to budget your spending with confidence and never be caught off guard when payment due dates arrive.
Flexibility
While you can use a home equity loan to consolidate and pay down costly debts, you’re not limited to that purpose. You can use the funds for anything you want, whether that be a new car, a fancy wardrobe, or a summer vacation.
Long repayment schedule
Home equity loan terms range from 5 to 30 years, so you can spread your payments over a long time period. That means you’ll make smaller monthly payments, easing the pressure off your budget.
Cons of using a home equity loan to pay off debt
Every loan comes with risks — and home equity loans are no exception. If you have sufficient home equity to take out a loan, understand these drawbacks before applying.
Home endangerment
A home equity loan is registered on your property’s title, meaning your lender can legally take ownership of the property or force you to sell it if you stop making payments. Quite simply, you risk losing your home when you use it as collateral for a loan.
Fees and closing costs
Home equity loans often come with additional expenses, including appraisal fees, title search fees, title insurance, and legal costs. These additional outlays can add up, reducing the overall savings you expected after being approved for the loan.
Tough qualifying requirements
Depending on the strength of your finances, you may not be eligible to get a home equity loan. Banks and credit unions typically approve borrowers who have a good credit score (generally 650 or higher), along with a stable income and a low debt-to-income ratio. You’ll also need to pass the mortgage stress test (if borrowing from a federally-regulated lender) and have at least 20% equity in your home for a lender to consider your application.
Debt problems can worsen.
Consolidating multiple high-interest debts into a home equity loan can provide immediate relief. However, it’s essentially just swapping one form of debt for another, with no reduction in principal. Because you can borrow a large sum of money, a home equity loan can also encourage you to spend beyond your means. If you’re not careful, you could find yourself back in financial trouble.
What is a consumer proposal?
A consumer proposal is a legally binding agreement made with your unsecured creditors to repay a portion of what you owe. Under a consumer proposal, your unsecured debts are combined, and you’ll make one monthly payment over a period of five years with no interest or penalties. After completing your last payment, your debts are considered to be paid in full. As a result, you’ll be released from all financial obligations to your unsecured creditors.
A consumer proposal is a federally regulated program governed by the Bankruptcy and Insolvency Act (BIA). It’s the most popular alternative to bankruptcy in Canada and is administered by a Licensed Insolvency Trustee (LIT). It’s not a loan, so it doesn’t involve borrowing money as with a home equity loan or other forms of debt consolidation.
The advantages of a consumer proposal over a home equity loan
There are several reasons to file a consumer proposal instead of a home equity loan to pay off expensive debts.
Significant debt reduction
Under a consumer proposal, you negotiate a new repayment agreement with your creditors to pay a percentage of your debts. Depending on your situation, you may be able to eliminate up to 80% of your balance, resulting in a much lighter debt load.
That’s not something you can achieve with a home equity loan or other debt consolidation loan. You’d still be responsible for repaying 100% of the principal, regardless of your credit score or earning power.
No risk of home loss
There’s no risk of your lender foreclosing on your home when you enroll in a consumer proposal. Legally, your unsecured creditors cannot seize your home or any of your other assets. Your only obligation is to repay the debts as agreed to under your proposal.
Consumer proposals do not affect your assets because the process involves only your unsecured creditors, which excludes mortgage lenders and other entities that issue home equity loans and HELOCs.
Legal protection from creditors
After filing your proposal, the court process automatically puts in place a stay of proceedings, which stops all collection efforts and legal actions by unsecured creditors. They won’t be able to contact you to demand payment, garnish your wages, or extract money from your bank account. This legal shield stays in place until you make your last proposal payment.
Zero interest charges
Unlike a home equity loan, you’ll never pay a dollar of interest under a consumer proposal. By avoiding interest entirely, you’ll garner significant savings and escape the clutches of high-interest debts in just a few years.
Option to pay off the proposal early
While you have up to five years to complete your proposal, you can speed up the process at your discretion. You can pay off your proposal early without incurring a prepayment penalty. For example, if you earn a hefty bonus from work, simply notify your LIT that you’d like to increase your regular proposal payment for the upcoming month.
Easier qualification criteria
Qualifying for a consumer proposal is far less stringent than qualifying for a conventional home equity loan. You don’t need to have a specific credit score, pass the mortgage stress test, or have a low debt-to-income ratio to be eligible. Getting approved hinges mainly on having an adequate income to repay at least a portion of what you owe.
Drawbacks to consider before filing a consumer proposal
Despite the unique benefits it offers, a consumer proposal comes with some drawbacks you need to assess before filing. Below, we break down the most important ones. To learn more, check out our article about the pros and cons of a consumer proposal.
Lower credit score
The most notable disadvantage is the negative impact on your credit. When filing a proposal, you’ll get hit with an R7 rating, indicating that a debt settlement is taking place. As a result, lenders will view you as a high-risk borrower, so you’ll have a harder time obtaining loans for a few years. However, an R7 remark on your credit report is still less severe than an R9 rating, which appears during bankruptcy and is harder to recover from.
Certain debts don’t qualify
There are strict rules about the types of debts you can include in a consumer proposal. Primarily, only unsecured debts qualify, such as credit cards, lines of credit, payday loans, and past-due utility bills. Some examples of debts disallowed under a consumer proposal are:
- Secured debts, such as an auto loan and mortgages
- Government student loans that are less than seven years old
- Alimony and child support payments
That being said, by lowering your unsecured debt payments through a proposal, you’ll have an easier time managing these other financial obligations.
The bottom line of home equity loans and consumer proposals for debt management
Home equity loans are a viable tool for paying down debts like credit cards, payday loans, and lines of credit. With the right loan, you can save a tremendous amount on interest and pay off your balance faster. You can also take your time making payments since home equity loans offer long terms, some lasting decades.
However, from our experience, people who are stuck in a cycle of costly unsecured debts don’t benefit from swapping one debt for another. Traditional debt consolidation only works if you’re financially stable and earn a solid income, as all you get is a reduction in the interest rate.
On the flipside, a consumer proposal reduces your principal and eliminates all interest charges, providing more significant financial relief. That’s something a home equity loan doesn’t offer.
If you’re struggling financially and looking to slash your debt payments, a Licensed Insolvency Trustee can help you review your options and choose one that works best for you. Get started on your journey to becoming debt-free by booking a free consultation today with David Sklar & Associates.
