Should You Use a HELOC to Consolidate Debt?

If you own a home, there’s a chance you have equity that could be used to consolidate the other debts you owe.

This could be accomplished by using a home equity line of credit (HELOC).

For some, using a HELOC to consolidate debt is a smart move that gives them a chance to turn their financial lives around.

For others, consolidating debt using a HELOC is a major mistake that will cause more financial pain.

Here’s what you need to know about using a HELOC to consolidate debt.

How to Use a HELOC to Consolidate Debt

Using a home equity line of credit to consolidate debt is a fairly straightforward process.

First, you’ll need to get approved for a HELOC. The approval requirements will vary from lender to lender.

That said, you normally need to meet a few requirements to qualify.

Getting Approved for a HELOC

To get a HELOC, you’ll need to have equity available in your home.

Your equity is most often calculated by getting an appraisal to determine the value of your home.

Your equity is the appraised value less the amount you owe on your mortgage.

Now:

In general, most lenders will limit you to having no more than an 80 percent loan to value ratio after using your HELOC.

This means the amount of your original mortgage plus the amount you plan to borrow from your HELOC should not add up to more than 80 percent of your home’s value.

Next, you’ll need to have a strong credit score to qualify.

The higher your credit score is, the better chance you have to be approved. Higher credit scores usually help you secure a lower interest rate, too.

You’ll also need to have a sustainable debt-to-income ratio.

Most lenders look for your debt-to-income (DTI) ratio to be 43 percent or less. That said, some lenders will approve slightly higher DTI ratios.

You can calculate your debt-to-income ratio by taking the total amount of your monthly debt payments divided by your monthly gross income.

Multiply the result by 100 to get the ratio as a percentage.

Using HELOC Proceeds to Consolidate Debt

Once you’ve been approved for a home equity line of credit, you can start using the line of credit to consolidate your debt.

Consolidating your debt means moving many debts to a single debt. In this case, you’d be moving debts from credit cards, car loans, personal loans and other debt to your home equity line of credit.

But how do you pay off your old debts using your HELOC?

Most HELOCs allow you to access your line of credit by writing HELOC checks.

All you need to do is write a HELOC check to pay off your old debt and send it to your old creditors.

You may need to check with your creditors in advance to get a pay off amount.

A pay off amount tells you the exact amount you need to pay by a certain date to make sure you cover all interest payments you’ll owe.

By doing this, you’ll avoid having to make one more final payment to cover any additional interest that you may not have otherwise included if you didn’t ask for a pay off amount.

Your creditors will use the check to pay off your debt. Each check you write from your HELOC will add to the balance you owe on your line of credit.

When writing checks to consolidate debt, make sure you don’t write checks in excess of your available line of credit.

Benefits of Using a HELOC to Consolidate Debt

There are a couple good reasons why you may want to use a HELOC to consolidate your debt.

HELOCs are a type of secured debt.

While secured debt can have downsides, one positive factor of a secured line of credit is you’ll likely receive a lower interest rate than you would on unsecured debt.

If you have a lot of higher interest rate debt, moving that debt to a home equity line of credit could substantially reduce the interest rate you pay on the debt.

HELOCs can also help you simplify your financial life.

Rather than having to remember to pay many bills each month, consolidating debt could reduce the number of debt payments.

Why It Isn’t Always a Good Idea

While using a HELOC to consolidate your other debt may make life easier and reduce your interest rate, there are quite a few reasons it isn’t a good idea.

You may end up paying more interest

A HELOC may offer a lower interest rate, but you may actually end up paying more interest over the life of the loan.

How is that possible?

Time.

Many types of loans have shorter repayment terms than HELOCs.

Car loans typically last three to eight years. Personal loans typically must be repaid over one to eight years.

A HELOC is usually repaid over a ten to twenty year time period.

The longer a loan’s repayment term is, the more interest you’ll end up paying.

If you plan to repay your HELOC according to the minimum payments, you’ll have to run the numbers to see if a HELOC will result in paying less interest than your current loan. In some cases, it won’t.

Your home is collateral

If you’re consolidating unsecured debt using a HELOC, you could be making a big mistake.

If you miss a payment on your unsecured debt, the lender can’t foreclose on your home.

When you consolidate your debt to a HELOC, the debt is now backed by your home. The lender can take your home if you default on your home equity line of credit.

Most people don’t anticipate defaulting on their HELOCs.

However, if you hit rough times, you’ll have to make your HELOC payment to avoid foreclosure.

If you don’t consolidate, you won’t have to make payments on your unsecured debt to keep your home.

Less home equity

If you consolidate a significant amount of debt, your home’s equity could be greatly reduced.

You could end up owing more on your home than it’s worth if the housing market declines.

Unless you pay money to sell your home, you’ll be stuck.

This means any job opportunities that involve relocation would require you to rent out your home, let your home go into foreclosure or turn down the opportunity.

Debt spiral

After you consolidate debt with a HELOC, you’ll find yourself with accessible credit again.

Unless you’ve made a major lifestyle change, that available credit could end up being used to dig yourself further into debt.

Should You Consolidate Debt with a HELOC?

Even though there are more risks than benefits when it comes to consolidating debt with a HELOC, it can still be a good move in certain cases.

If you’ve sworn off consumer debt and are now working diligently on repaying your debt ahead of schedule, using a HELOC may be a good idea. You could save quite a bit on interest payments by consolidating high interest rate credit card debt.

Remember:

HELOC repayment periods typically last 10 to 20 years.

The key is paying off the HELOC quickly and ahead of schedule.

This allows you to take advantage of the lower interest rate HELOCs offer without falling into the trap of the long repayment period.

However, if you haven’t figured out how to get your spending under control, you will likely end up further in debt.

You need to develop discipline before you attempt to consolidate debt with a HELOC.

Hoping you’ll develop discipline after you consolidate is a recipe for disaster.

Additionally, consolidating certain types of debt probably isn’t the best idea.

In particular, consolidating federal student loan debt using a HELOC usually isn’t a good idea.

Federal student loan debt offers a number of unique options that HELOCs and even private student loan debt don’t offer.

For instance, federal student loans allow you to set up one of many different types of repayment programs, including an income-based repayment plan, depending on your needs at the time.

Federal student loans also offer forbearance, deferment, and public student loan forgiveness options.

You would lose all of these benefits by consolidating federal student loans using a HELOC.

Other Ways You Can Consolidate Debt without a HELOC

You don’t have to use a HELOC to consolidate debt. In fact, you have quite a few other options.

Unsecured personal loans

Unsecured personal loans allow you to consolidate debt without putting up any assets as collateral.

Unfortunately, interest rates will be higher than with secured debt. Even so, they could still be lower than high interest rate credit card debt and payday loans.

One benefit of an unsecured personal loan is you don’t have to worry about losing your assets should you hit hard financial times.

Balance transfer credit cards

If you plan to pay your debt off quickly, a 0% APR balance transfer credit card offer may be just what you need.

These offers allow you to transfer your debt to the credit card and pay no interest during the introductory period which typically lasts from 12 to 18 months.

Be careful, though.

These offers often have balance transfer fees which usually range from three to five percent of the balances you transfer.

Additionally, you’ll be stuck paying the usual interest rate if you don’t pay the transferred debt off before the promotional zero APR period expires.

Student loan hardship programs and refinancing

If you want to consolidate your student loan debt, you could use the Direct Consolidation Loan program.

However, you can only use this for federal student loan debt.

If you want to consolidate all of your student loan debt, including private student loans, into one loan, you should look into refinancing your debt.

However, don’t forget refinancing federal student loan debt to private student loan debt will result in the loss of benefits detailed above.

You may want to look into student loan hardship programs if you just need some breathing room.

There are alternative payment plans for federal student loans, such as the income-based repayment plan, that may help you lower your payments.

Do What Works for You

Ultimately, only you can decide if consolidating your debt using a HELOC is a good idea in your particular situation.

Think through every possible angle before you decide to make the move.

Once you consolidate your debt, there’s no undo button if you realize you made a major mistake.