Every year thousands of homeowners consider consolidating unsecured debt using their home equity. But is this a wise decision? In this article, I will cover when you should consider consolidating unsecured debt with your home equity, the three main options for homeowners, general underwriting guidelines, and alternatives.
I will also cover when you should avoid consolidating your unsecured debt and alternatives to consider.
What Is Unsecured Debt?
Unsecured debt is money you owe, not backed by a physical asset. Examples are credit cards, personal loans, and student loans. The opposite of that is secured debt. Secured debt is money you owe that is backed by a physical asset. Examples include your mortgage and car loan.
According to the Federal Reserve Bank of New York, total outstanding credit card debt was $927 billion, and mortgage debt at the end of 2022 was $11.92 trillion.
When You Should Consider Consolidating Unsecured Debt With Your Home Equity
According to the Wall Street Journal, Americans have $27.8 trillion of home equity. Here are the situations you should consolidate unsecured debt using your home equity.
You Have a Significant Amount of Unsecured Debt
For homeowners with a significant amount of unsecured debt, consolidation of that debt using their home equity might be their best financial option. How do you determine if you have a significant amount of unsecured debt?
Here are a few questions to help you determine if you have too much unsecured debt.
- Do you only make the minimum payments?
- Does the amount of unsecured debt cause you stress?
- If you had no income for three months, would you pay able to make all your monthly expenses and not incur new debt?
- Is your unsecured debt more than 15% of your annual income?
You might have too much unsecured debt if you answered yes to one or more of these questions. You should consider your options and look at using your home equity to consolidate your unsecured debt.
The Interest Rate On Your Unsecured Debt Is High
Everyone loves a 0.00% balance transfer offer, and everyone hates the rate once that expires, especially in 2023. Credit card rates have historically been over 20%, and when they are that high, it’s time to consider consolidating your unsecured debt, especially if your unsecured debt is more than 15% of your annual income.
Your Unsecured Debt Payments Are No Longer Manageable
Here is how you know if your unsecured debt payment is no longer manageable.
- You’re struggling to make the minimum payments on your unsecured debt
- Your monthly debt payments are going higher
- You are more than 30 days late on one or more accounts
If you fall under one or more of these examples, your unsecured debts should be addressed immediately. Using your home equity to consolidate your debt might be the best option to put you on a better path to growing your wealth.
Which Loan Option Is Best When Consolidating Unsecured Debt?
If you are going to consolidate your unsecured debt using your home equity, there are three main loan options to consider.
- Cash-out refinance of your first mortgage
- Home Equity Line of Credit
- Home Equity Loan
- Home Equity Investment
Here are the pros and cons of each loan option.
Cash-out Refinance
For most homeowners, a refinance of their first mortgage is the most common option utilized to consolidate unsecured debt. Usually referred to as a “cash-out refinance,” this loan option combines your first mortgage with your unsecured debt so that post-closing, you only have one loan and no unsecured debt.
| PROS | CONS |
|---|---|
| Fixed-rate option | Costs might be high |
| Multiple loan structures available | You’ll need an appraisal |
| One loan post-closing | Resetting your mortgage term |
Refinancing your mortgage gives you the option to lock in a 15, 20, 25, or 30-year fixed rate. Other than the costs might be high, the biggest negative is the resetting of your mortgage term. This means if you currently have 25 years left on a 30-year fixed rate mortgage and you refinance to a new 30-year mortgage, you are “resetting” back to the full 30-year term.
One way to avoid this is to consider a term that matches the number of years you have left on your current mortgage or a shorter term.
Home Equity Line of Credit
When first mortgage rates are significantly higher than your current rate, your best option might be a Home Equity Line of Credit (HELOC).
| PROS | CONS |
|---|---|
| Low rates (under a normalized interest rate environment) and minimal fees | Adjustable rate can increase |
| Faster closing than a refinance | You might need an appraisal |
| 5 to 10-year draw period, with interest-only payments | Two loans instead of one |
Many homeowners prefer a HELOC to a refinance of their current mortgage. Just make sure you fully understand the adjustable-rate aspect of a HELOC and that your initial minimum monthly payment is an interest-only payment.
Home Equity Loan
For homeowners who want to avoid the adjustable rate associated with a HELOC, your best option might be a Home Equity Loan (HELOAN).
| PROS | CONS |
|---|---|
| Fixed rate loan | Higher monthly payment (fully amortized) |
| Minimal fees | You might need an appraisal |
| Faster closing than a refinance | Two loans instead of one |
The benefits are significant if you have a low first mortgage rate and want to avoid an adjustable rate when consolidating your unsecured debt.
Home Equity Investment
A home equity investment, also sometimes called a home equity sharing agreement or shared equity financing agreement, is a financial arrangement in which an investor or investment firm provides a homeowner with a lump sum of cash in exchange for a share of the future increase in the value of the home. It’s not a loan, so the homeowner doesn’t make monthly payments to the investor. Instead, the investor gets their return when the home is sold, or at the end of a predetermined term, usually ranging from 10 to 30 years.
Here are some key points:
- The money received can be used for any purpose, such as home improvements, debt consolidation, or to cover other expenses.
- The homeowner retains full ownership and control of their home. They continue to live in the home and are responsible for all expenses and maintenance.
- The amount the investor will receive depends on how much the home appreciates in value over the term of the agreement. If the home’s value increases significantly, the investor stands to make a substantial return. Conversely, if the home does not appreciate as expected, the investor may not recoup their full investment.
- If the home depreciates in value, some agreements stipulate that the homeowner does not owe anything. However, terms can vary widely, so it’s essential to understand the specifics of the agreement.
- Home equity investments typically do not have a fixed term. The homeowner can typically buy out the investor’s share at any time, although there may be minimum periods and costs involved.
While this can be a way for homeowners to access the equity in their homes without taking on debt, it’s important to carefully consider the potential long-term cost. The equity given up could amount to a significant sum if the home appreciates considerably over the term of the agreement. As with any financial agreement, it’s important to thoroughly understand the terms and potential risks before proceeding.As a homeowner, you should evaluate your options and weigh the pros and cons of each solution. Talking with a financial advisor and/or a CPA would be helpful.
Debt Consolidation Underwriting Requirements
Each mortgage lender will have their own underwriting requirements; however, some universal guidelines exist. Below I’ll cover lenders’ main guidelines, and you’ll want to discuss this further with your loan officer.
Credit score
Credit score underwriting guidelines usually require a mid-credit score of 620 or higher for a cash-out refinance loan. If you are considering a HELOC or a HELOAN, you’ll probably need at least a 680 or higher credit score. If you are considering a HEI, then your credit score can be much lower, or may not be considered at all.
And your best interest rates, and lowest fees, will happen for those with a credit score at or above 780.
Loan-to-value ratio
A Loan-To-Value (LTV) ratio is the value of your home compared to the amount you are borrowing. For a cash-out refinance, you’ll most likely be required to stay under an 80% LTV and a 90% or 95% LTV if you pursue a HELOC or HELOAN.
Debt-to-income ratio
Your debt-to-income ratio (DTI) is a key part of underwriting. Lender underwriting requirements for a cash-out refinance of a first mortgage generally call for a DTI ratio below 45%, and some lenders are a bit stricter and require a DTI at or below 40%.
Regarding HELOCs and HELOANs, lenders generally look for a DTI below 43%, although some lenders might go higher with compensating factors. Examples of compensating factors are:
- A higher-than-needed credit score and extensive credit history
- Being with the same company for ten years or more
- A low LTV ratio
If you’re DTI is high, talk with your loan officer to see what compensating factors you might have to help you obtain an underwritten approval.
Asset requirements
If you are refinancing your first mortgage, you might need to show liquid assets, especially if your DTI is above 40%. If so, you’ll need to be prepared to show enough cash reserves to cover your total mortgage payment for up to six months.
Some HELOC and HELOAN lenders require asset reserves, and if so, generally, they require enough cash reserves to cover two to three months of your total mortgage payment.
When providing asset statements, most underwriters will require you to provide your two most recent statements.
Pro Tip
When you send your asset statement, send in the entire statement, all pages, front and back of each page, even if it’s blank. Underwriters require this and make sure the copy they receive is clear and complete. Also, do not cross out or black out any information on the statement (it will be rejected if you do).
Consolidating Debt Depends On Current Mortgage Rates And Closing Costs
If you have a significant amount of unsecured debt, the interest rate on that debt is high, and/or your unsecured debt payments are no longer manageable; you should consider consolidating your unsecured debt if mortgage rates are attractive, and closing costs are not too high.
Since mortgage rates and closing costs change over time, you’ll want to compare your current rate, the proposed new rate, and the interest rate on your unsecured debt.
If you have a financial advisor, I suggest discussing your situation with them and your trusted loan officer to ensure you make an informed decision.
When You Should Avoid Consolidating Unsecured Debt With Your Home Equity
Paying off unsecured debt with your home equity is sometimes a good idea. Here are examples of when it does not make sense and an alternative option should be found.
You Are Close To Paying Off Your Home Mortgage
If you are close to paying off your home mortgage, you should think twice about using your home equity to payoff your unsecured debt, especially if you’re considering a new 20-year or 30-year mortgage.
Your Unsecured Debt Is Manageable
If your unsecured debt is low and/or has a low-interest rate compared to current rates, you should avoid using your home equity to consolidate your unsecured debt.
The Interest Rate On The New Consolidation Loan Is Too High
It’s not a good idea to consolidate your unsecured debt if the new consolidation loan has an interest rate that is too high. For example, if your credit card debt is at 11% and a new first mortgage is going from 3.5% to 7.5%, you might want to reconsider consolidating your unsecured debt and look at alternatives.
The Fees To Consolidate Your Debt Are Too High
Be careful of paying high lender fees to consolidate your unsecured debt. For example, if you have $50,000 in unsecured debt and a current mortgage balance of $322,000, you’ll usually want to ensure your total fees for everything are under $7,444, which is 2% of the loan amount (which is where I recommend you cap the cost of the transaction).
Pro Tip
When obtaining a new mortgage, HELOC or HELOAN, paying attention to your total fees is just as important as your rate. Make sure you look at the breakdown of the costs and the total fees being charged.
Risks to using a home equity loan to pay down unsecured debt
As discussed, consolidating unsecured debt with a home equity loan could be a good idea because it often provides lower interest rates and potentially tax-deductible interest. However, this approach comes with several risks that are important to consider:
- Risk to Your Home: Perhaps the most significant risk is that your home is now collateral for your debt. If you default on the loan, you risk foreclosure. If you are unable to meet your monthly payments, your home could be seized by the lender.
- Longer Repayment Period: Home equity loans typically have longer repayment terms than most unsecured debts. This means that even if your monthly payment is lower, you may end up paying more in interest over the life of the loan.
- Potential for More Debt: If you consolidate your debt but don’t address the behaviors that led to the debt in the first place, you may find yourself accumulating more unsecured debt. This can lead to a vicious cycle of borrowing.
- Closing Costs and Fees: Home equity loans usually involve closing costs and fees, which can add to the total cost of the loan. Make sure you take these into account when calculating potential savings.
- Variable Interest Rate Risk: Some home equity lines of credit (HELOCs) have variable interest rates. If rates increase significantly, your monthly payment could also increase.
- Tax Implications: The tax deductibility of home equity loan interest can be complex and has changed with recent tax law changes. You should not assume that the interest will be tax-deductible without consulting with a tax professional.
In sum, while a home equity loan can be a tool to consolidate and pay off debt, it isn’t without risk. You should make sure to carefully consider your ability to pay, changes to your lifestyle, and consult with financial advisors or credit counselors to ensure you make the best decision for your situation.
Alternatives To Using Your Home Equity
Here are alternative options for consolidating your unsecured debt without using your home equity.
- Consolidate debt into a lower interest rate with another credit card (i.e., a balance transfer)
- Debt consolidation personal loan
- Credit counseling
- Debt settlement
These are alternatives that have worked for homeowners in the past. Finding your best choice should include reviewing these options and talking with a financial advisor.
Consolidating Unsecured Debt With Your Home Equity
Deciding if consolidating your unsecured debt using your home equity is a decision only you can make. Researching, educating yourself, and talking with industry professionals can help the decision-making process.
If you decide to consolidate your unsecured debt using your home equity or an alternative method, you want to ensure your financial picture improves both in the short and long term.
