Are you stuck with burdensome credit card debt, unsecured lines of credit, payday loans, or other high-interest debts and looking for a way to eliminate them? If so, you may have contemplated tapping into your home equity to pay it off. If you’ve done some research, you may have heard financial professionals touting how using home equity can lower your monthly payments and help you pay off your debts faster. But is it all true or just hype? And are there any hidden risks to consider?
In this article, we’ll explore how consolidating your debts using your home equity works and show you three ways to do it. We’ll also explain the pros and cons of this strategy and outline some alternative solutions. By the end, you’ll have a clear idea of whether accessing your home equity is the ideal way to deal with your debts.
What is home equity – and how can you use it to pay off your debt?
Home equity is your property’s market value minus your outstanding mortgage. In other words, it’s the portion of your home you own outright, meaning no one else has a stake in it.
For example, if your home is worth $800,000 and you currently owe $525,000, you have $275,000 in home equity. Once you pay off your mortgage in full, you’ll have 100% equity or ownership rights to your property.
So, how exactly can home equity help you better manage your credit card debt and other high-interest loans?
The answer is that it lets you consolidate your existing debts under a single loan using your home equity as collateral. Basically, you apply for a new loan and use the proceeds to pay off what you owe on your credit cards, payday loans, past-due bills, etc.
But what’s the point of trading one debt obligation for another?
The reasoning is that, when done right, borrowing money through your home equity will lower your interest costs and help pay off your debts faster.
A loan backed by home equity is a form of secured debt, as your home functions as collateral. That means your lender can sell it to pay off the balance owed should you stop making payments. Since this reduces their risk, they’ll be more willing to lend you money at a low interest rate – much lower than what you pay for credit cards and other unsecured debts.
The savings in interest associated with accessing home equity is the primary reason why it’s such an attractive option for many people struggling with high-interest debts.
How much can you borrow through your home equity?
The amount of money you can access through your home equity will depend on several factors. These include your financial stability, federal regulatory guidelines, and the internal policy of your lender.
Generally, the maximum amount you can borrow is between 65% and 80% of your home’s appraised value, less what you owe on your mortgage. The Office of the Superintendent of Financial Institutions (OFSI) sets and enforces these limits, meaning all federally regulated financial institutions must abide by them when issuing loans.
Alternative lenders or those regulated at the provincial level may be more generous and willing to provide funds up to 90% of your home’s value, as they’re not subject to federal laws.
Aside from regulatory guidelines, your financial situation will strongly impact your borrowing capacity. Lenders will consider your credit score, existing debt obligations, and income when reviewing your application. In general, the better shape you are in financially, the more money you’ll be able to borrow via your home equity.
How to borrow money by accessing your home equity
In this section, we’ll explain how to borrow funds through your home equity using a HELOC, home equity loan, and cash-out refinance.
HELOC
A home equity line of credit (HELOC) is a line of credit secured by your home. As with a standard line of credit, you can draw funds up to a preset credit limit assigned by your lender. You pay interest only on the amount you use and can reborrow the funds as needed.
You can borrow up to 65% of your home’s value through a stand-alone HELOC (one not tied directly to your mortgage), less your outstanding mortgage balance. The same limit applies to HELOCs that are part of a re-advanceable mortgage.
If your re-advanceable mortgage is from an institution not bound by federal lending limits, such as a credit union, you could potentially borrow more than 65%.
Suppose that you financed your home purchase using a combination of a HELOC and a mortgage. In that case, your borrowing capacity increases to 80%. However, the maximum amount you can borrow through the HELOC portion is still capped at 65% of your home’s value. The additional 15% of borrowing power must originate from your mortgage.
Home equity loan
A home equity loan (sometimes called a second mortgage) functions like an installment loan, except that your home functions as collateral. Under this loan type, your lender will provide you with a one-time lump sum of money, which you must repay monthly over a defined period with interest.
Lenders in Canada will usually allow you to borrow up to 80% of your home value, less your mortgage balance.
Cash-out refinance
A cash-out refinance allows you to convert your home equity into cash by refinancing your mortgage. Under this option, you obtain a new mortgage larger than your current balance, and your lender pays you the difference between the two. You can then use this lump sum to settle your debts. From there, you’ll repay the principal and interest through your new mortgage.
Under a cash-out refinance, you can borrow up to 80% of your home’s market value less your outstanding mortgage.
To qualify for refinancing, you’ll need at least 20% equity in your home (among other things); this is the minimum most lenders will accept.
Pro of using home equity to pay off your debts
Let’s look at how accessing your home equity to consolidate can be a wise move.
Lower interest rates. The biggest advantage of tapping into your home equity for debt consolidation is the lower interest rate you pay. Compared to personal loans, credit cards, and other unsecured credit, rates on loans secured by your home equity are significantly cheaper. For example, the average interest rate for a credit card is 19.99%. In contrast, it’s possible to obtain a HELOC that doesn’t exceed single-digit rates, as RateSpy shows.
Pay off debt faster. Since HELOCs and home equity loans chargelower interest rates than unsecured debts like credit cards, you’ll pay off your principal sooner. The fewer interest charges that collect on your balance, the faster it will shrink.
More flexibility. Repayment terms under a HELOC offer tremendous flexibility, allowing you to tailor your payment plan to fit your needs and budget. With a home equity loan, you can choose from a wide range of payback terms, which will dictate the size of your monthly payment.
One monthly payment. When you consolidate your debts through your home equity, you’ll only be responsible for making one monthly payment. This arrangement can be a huge convenience and relief if you have a hectic lifestyle, as you’ll no longer have to juggle multiple payments.
High borrowing limits. A key advantage of home equity financing is that your borrowing capacity is higher than other types of credit products. You can access up to 80% of your home’s value minus the outstanding mortgage. This can translate to a tremendous amount of money, which can easily cover your debts, past-due bills, and more.
Cons of using home equity to pay off your debts
Here are some of the shortcomings of using home equity to eliminate high-interest debts.
Your home is at risk. When you borrow by leveraging your home equity, your home is collateral. As a result, if you miss too many payments, your lender can repossess your home to recover the money owed. The risk of property loss is heightened with a loan product like a HELOC, as it’s a callable loan, meaning your lender can demand full payment of the principal immediately if you fall behind
You need equity in your home. You’ll need a sufficient amount of home equity in your home to qualify for a HELOC, home equity loan, or refinancing. Most lenders will expect at least 20% equity before considering your application.
Lenders may restrict your borrowing power. Just as quickly as your lender can provide you access to a wad of cash under a HELOC, they can take away the privilege instantly if your financial situation deteriorates. For example, if your home value plummets, they may reduce your credit limit or freeze your account. They may do the same if your credit score drops sharply or you take on too much debt.
Numerous fees to pay. Using your home equity to borrow money may require you to cover various administrative costs, especially if you refinance or get a second mortgage. These may include appraisal, title insurance, legal, and title search fees.
Tough eligibility requirements. Getting access to home equity to pay off debts can be challenging and frustrating. First, you’ll need to pay the mortgage stress test again. Second, you’ll need to demonstrate that your financial house is in solid shape. For a HELOC or home equity loan, you’ll need a good to excellent credit score, which means a minimum score of 650 or over 700 to qualify for the best rates and terms. Lenders will also expect a reliable income and low debt-to-income ratio.
Alternative ways to deal with high-interest debts
Debt consolidation loan. A debt consolidation loan is a type of personal loan. It allows you to merge unsecured debts, like credit cards, payday loans, and store cards into one large balance. Interest rates on debt consolidation loan tend to be lower than those charged on most unsecured debts. A debt consolidation loan’s most notable advantage over home equity-based loans is that it won’t endanger your home. There’s no requirement to list your property as collateral to qualify.
Balance transfer credit card. If you have good credit, consider moving your debts to a balance transfer credit card. Many of these credit cards offer promotional periods where you pay a low or zero-percent interest rate for periods ranging from six to 18 months. A lower rate will provide temporary financial relief, saving you money on interest charges and helping you pay off your balance sooner.
Debt management plan. A debt management plan (DMP) is a debt relief program administered by a nonprofit credit counselling agency. Essentially, a credit counsellor will negotiate a new debt repayment schedule with your creditors, ideally one you can afford. While you’ll still be responsible for repaying 100% of the principal, your creditors may agree to reduce and, in some cases, eliminate your interest charges. Under a DMP, the credit counsellor will pool your existing debts. Then, each month, for up to five years, you’ll make a single payment to the agency, which will then distribute the money to your creditors. There’s no requirement to put your home or other asset as collateral to enroll in a DMP.
Proper money management. Sometimes, you can dramatically reduce your debt load by rethinking your approach to handling money. With the right plan, you can revamp your finances by optimizing how you manage your cash flow, debt payments, expenses, and income. Learn more about effective debt management.
Consumer proposal. A consumer proposal is a federal debt relief program that allows you to discharge a sizable portion of your unsecured debts, sometimes up to 80%. Only a Licensed Insolvency Trustee (LIT) can administer a consumer proposal in Canada. This unique program works similarly to a DMP in that your LIT will negotiate a reduced payment plan with your creditors. You’ll then pay this amount over five years and your remaining balance will be forgiven when the payment plan is completed. No interest charges will accrue, and you’ll receive legal protection from creditor actions. And most importantly, you won’t need to give up your home.
Final thoughts on using home equity to pay off debts
Using your home equity to pay off debts can be a smart move financially if most of the following applies to you:
- You can readily borrow funds at a significantly lower rate than the average rate of your current debt obligations.
- You have sufficient equity in your property (at least 20% in most cases).
- You have a high credit score (650+; the higher, the better)
- You can pass the mortgage stress test (if borrowing from a federally regulated lender)
- You earn a steady income that allows you to comfortably pay off a home equity loan, HELOC, etc.
- Your overall finances are in reasonable shape – you’re simply looking for a way to save on interest costs and pay off your debts sooner to avoid future debt problems.
- You’re okay with putting up your home as collateral.
On the other hand, Let’s assume that your finances are in dire shape. You have a low credit score, a high debt-to-income ratio, and an unreliable income. In this scenario, your chances of qualifying for a HELO, home equity loan, or similar financing are slim. Even if you manage to borrow funds using your home equity, it could be a high-interest rate and unfavorable terms. You’d simply be swapping one type of debt for another with no benefits.
Furthermore, with a low or inconsistent income, there’s a higher risk that you’ll fail to keep up with your loan payments, which means your lender can legally foreclose on your home. Unless you’re fully confident in your ability to repay what you owe, it’s best to avoid borrowing against your home equity and jeopardizing your home.
If your debt problems and financial situation are severe, better options may exist than accessing your home equity. You may achieve more success by pursuing one or more of the alternatives in this article, such as a consumer proposal and DIY debt relief strategies.
If you need advice on moving forward, contact David Sklar & Associates for a free, no-obligation consultation about managing your debt.
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