High-interest credit card debt is no joke. Interest alone can add years to the time it takes you to pay off your debt. One option is to consolidate those debts and pay them off with a line of credit backed by the equity you have in your home. This is known as a home equity line of credit (HELOC).
What is a home equity line of credit?
A HELOC is a revolving credit line that usually has a lower interest rate than credit cards and other types of revolving loans. It works somewhat like a credit card, in that you can borrow money as needed up to a certain limit. Like a credit card, a HELOC has a variable interest rate.
There’s one big difference: Your home is collateral for the loan. If you default on the loan, you could face foreclosure on your home.
With a HELOC, you borrow money during what’s called the draw period. This is a specified time period when you can withdraw money against your credit line.
You’re not obligated to borrow it all at once. You can choose to borrow all or just some of the available money. During the draw period, you only have to pay interest on the borrowed amount, though you can pay more. A typical draw period lasts up to 10 years, depending on the terms of the loan.
Once the draw period ends, you can’t take out any more money and you have to start repaying the loan’s principal in addition to interest. LendingTree has detailed information about HELOCs, with a handy feature that lets you compare HELOC rates and offers.
How much can you borrow? That’s determined by what your new loan-to-value (LTV) ratio will be if you take out a HELOC. Your LTV is your mortgage balance plus the amount you’re looking to borrow, divided by your home’s market value.
Here’s an example of how it works. Let’s say your home’s value is $100,000 and you have $50,000 left to pay on your mortgage. You’d like to take out a $10,000 HELOC. Add $50,000 and $10,000 and you get $60,000. Divide that by your home’s value: $100,000. That gives you an LTV of 60%. That’s well below the maximum 80%-90% LTV many lenders impose.
Why use a home equity line of credit for debt consolidation?
The main reason to pay off high-interest credit card debt with a lower-interest HELOC is that you can become debt-free faster. Note that you could also use a home equity loan (HEL) to do this. A home equity loan is a fixed-rate installment loan: You get a large lump sum of money and repay it with payments that are the same amount every month.
But with a HELOC, you can borrow smaller amounts as you need them. And you only repay what you borrow. The closing costs for HELOCs are typically lower than those of home equity loans or traditional mortgages.
The downside of consolidating credit card debt with a HELOC is that your home is the collateral, meaning that you could lose your house if you’re unable to pay back the loan. You need to be absolutely sure you’ll be able to pay off the loan before you take it out.
Also, since the interest rate is variable, rising interest rates could throw off your monthly budget.
In addition, the interest you pay on a HELOC is no longer tax deductible if you use it for debt consolidation. You used to be able to deduct the interest no matter what you used the loan for. But under the Tax Cuts and Jobs Act of 2017, you can only take that deduction if you use it to “buy, build or substantially improve” your home, according to the Internal Revenue Service.
How to qualify for a home equity line of credit
To determine your eligibility and credit limit, lenders will look at your ability to repay the loan by examining your income, debts and other financial obligations, as well as your credit history.
The minimum credit score to qualify is usually 620, which could get you an interest rate of around 12%, according to myFICO.com. However, with a score of 740 or higher you could potentially cut that rate in half to around 6%. That’s why it pays to check your credit score and shop around, as your interest rate can make a huge difference in your payments.
If you decide to apply for a home equity line of credit, the Consumer Financial Protection Bureau (CFPB) recommended reading the credit agreement carefully. You should examine the terms and conditions of various plans, including the annual percentage rate (APR), closing costs and other fees and charges.
Alternatives to a home equity line of credit for debt consolidation
If you decide that a HELOC is not for you, then you may want to take a look at other options for debt consolidation.
Cash-out refinance. One of your options is a cash-out refinance, which would pay your existing mortgage and give you a lump sum of cash on top of that. You’d then have a new mortgage to pay off for the larger amount.
Home equity loan. A home equity loan, which we discussed above, is another option. You might prefer it if you want the stability of having a set bill to pay every month, as a HEL comes with a fixed interest rate.
Personal loan. You might also look into getting a personal loan to pay off your debts. But because they’re not secured by collateral, personal loans usually have higher interest rates than a HELOC or HEL.
Balance transfer credit card. One last option is a balance transfer credit card, which allows you to transfer high-interest debt to a lower-interest credit card. Many balance transfer cards offer 0% interest for a year or even longer. But once the promotional period is over, the interest rate can skyrocket.
More borrowers are leveraging the equity in their homes. According to a TransUnion report, the number of homeowners taking out HELOCs between 2018 and 2022 is expected to hit 10 million — double the amount during the previous five years.
HELOCs can be particularly useful for paying down debt, but it’s important to be mindful of the terms and shop around for a loan that fits your situation. HELOCs aren’t for everyone, so make sure that you’re able to repay the loan without risking your home.