Understanding the Risks of Using a Home Equity Loan to Pay Off Debt
As a homeowner, your home equity is one of the critical assets that can provide a reliable funding source. Depending on the equity you have built, you can easily take on a lump sum loan or a home equity line of credit to finance necessary expenses, such as debt consolidation, unexpected emergencies, home improvements, and education costs.
And while this loan product is highly versatile and cheaper than unsecured loans, there are several risks to using a home equity loan to pay off debt. Keep reading to learn more about home equity loans and debt repayment. Call BMC Mortgage & Investments today for a consultation!
How Home Equity Loans Work
Assume you own a house or property that you bought with cash or a mortgage. So as the value of the house or property increases and as you make payments towards the mortgage, you'll build up equity. The latter is a portion of your property's value minus any liens or outstanding mortgage debt.
When taking out a home equity loan to pay off debt, the lender will calculate the loan amount you qualify based on the equity. Most lenders approve loans up to 95% of the home's equity. Before approving the loan, your lender will assess your home value, credit score, debt-to-income ratio, and the loan-to-value ratio.
Home equity loans' eligibility requirements are flexible. It often depends on the lender you work with and your unique financial situation. Factors such as the loan purpose, employment status, income, and risk profile also affect how the lender will impose the eligibility requirements.
Risks of Using a Home Equity Loan to Pay Off Debt
As noted earlier, home equity loans are versatile. You can use the loan to do virtually anything you deem fit. However, you are more likely to incur a slightly higher interest rate if you use the loan to pay off debts or fund speculative investments. But that's a small challenge if you are currently servicing some high-interest credit card loans. In fact, it would be a huge relief.
This brings us to the main disadvantage of using a home equity loan to pay off debt: you are "robbing Peter to pay Paul." In other words, you are simply transferring a problem from one lender to another. Here are the risks that come with this loan repayment technique:
- You risk losing your home. When applying for a home equity loan, you use your home or property as collateral. If financial challenges strike and you cannot repay your loan, you risk foreclosure.
- Your home's value can go negative. During global recessions or extended economic downturns, home prices can drop even by half the market value. If this happens, you could own more than your home is worth.
- The loan isn't a quick fix. As much as servicing the high-interest loans using a home equity loan will relieve some financial pressure, you'll still have a new and bigger loan to repay. This isn't a real solution to your money problem but a temporary relief.
Weigh Your Options
Using a home equity loan to pay off debt is popular among homeowners thanks to its many benefits. However, you don't want to go overboard and lose your home to foreclosure. Consider the abovementioned risks and consult a reputable financial advisor before tapping into your home equity to pay off debt. Call BMC Mortgage & Investments today!