Debt Consolidation: How to Use Home Equity to Pay Off High-Interest Debt

June 14, 2023 - 7 min read

Tap your home equity to pay your debts

Owe a lot of money to different creditors? Tired of managing different bills each month to pay off credit cards, student and vehicle loans, and other debts?

There’s a smart strategy that can simplify matters and hopefully reduce the total interest you will pay: debt consolidation. This involves combining multiple high-interest debts into a single lower-interest loan and you have three main options to choose from.

Each choice enables you to tap equity from your home to repay other outstanding debts. Learn more about each, their advantages and disadvantages, and the steps involved with using home equity before committing to debt consolidation.

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How home equity can be used for debt consolidation

If you have outstanding credit card bills, unpaid personal loans, and other debts that charge a high rate of interest, it’s likely going to take a long time to pay these off. With these, you’ll probably pay thousands in interest alone over many years, especially if you only pay the minimum balance due every month.

Instead, consider consolidating these debts, which involves combining multiple personally payable debts into a single payment.

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Often, the best way to consolidate debts is to choose a financing option that permits you to take out equity from your home. Your home equity is simply the difference between your property’s current market value and your mortgage loan’s unpaid principal balance. There are three main ways to tap into your home’s equity (without having to sell your home), which we’ll explore shortly.

Pros and cons of using home equity for debt consolidation

The biggest advantage of using home equity for debt consolidation is that you’ll probably be charged a much lower interest rate than what your individual loans and debts charge, explains Baruch Silvermann, CEO and founder of The Smart Investor.

“Home equity loans and lines of credit typically have lower interest rates than credit cards or personal loans. This can save homeowners lots of money in interest charges over time,” Silvermann says.

Additionally, consolidating debt into a single payment makes the repayment process simple. You only have to keep track of and pay one monthly payment.

You “can get all these debts paid off – including your mortgage – in a shorter timeframe if you opt for a cash-out refinance of your primary mortgage loan for a shorter term than you currently have,” said Aaron Craig, vice president of Mortgage and Indirect Sales for Georgia’s Own Credit Union. “If you currently have 20 years left on your primary mortgage, but reset the loan via a 15-year cash-out refinance, you’ll shave five years off of your repayment term. Plus, by using the cashed-out equity to pay off an existing car loan, you’ll own your car free and clear.”

On the downside, you’ll have to pay closing costs and fees if you proceed with a home equity loan, HELOC, or cash-out refi, which can equate to thousands of dollars (often 2% to 5% of the borrowed amount).

“Worst of all, you have to use your home as collateral with these home equity financing options. That means you risk losing your home if you fail to make payments,” cautions Andrew J. Hall, senior fund manager at Paperclip Asset Management.

Steps involved with using home equity for debt consolidation

There are several steps involved before tapping your home’s equity. First, you need to calculate the current market value of your home.

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“This can be challenging under current real estate circumstances. But you can use a real estate website or contact a local real estate agent to obtain an estimate of your home’s current value,” recommends Silvermann.

Next, take your outstanding mortgage balance amount and subtract it from your home’s current market value. This tells you how much equity you have accrued.

For example, if your property is worth $300,000 and you have a mortgage balance of $150,000, your home equity is $150,000.

Then, determine how much home equity you can realistically borrow from and how much in debt you actually need to consolidate. This involves totaling your outstanding debts on credit cards, personal loans, auto loans, and other high-interest financing to find out the total amount you owe.

Lenders typically use a debt-to-income ratio of 43% to determine how much you can afford to borrow. For instance, if your monthly income is $10,000 and you currently pay $1,500 per month toward your primary mortgage loan, you can probably afford to borrow – meaning liquidate equity – up to an extra $2,800 per month.

Lastly, decide what type of home equity financing is best for you after carefully shopping among different lenders and loan products and comparing the interest rates, fees, and repayment terms.

Home equity options for debt consolidation

As promised, here’s the lowdown on the three most common home equity financing vehicles you can pursue for debt consolidation purposes.

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Home equity loan for debt consolidation

With a home equity loan, your primary residence is used to secure the loan. If approved, you can tap into the equity your home has accrued. Home equity loans are second mortgage loans that work similarly to primary mortgage loans.

You are charged a fixed or adjustable rate of interest, you agree to a set repayment term (typically between five and 30 years), and you make monthly principal and interest payments each month after you close on the loan. Many mortgage lenders, banks, credit unions, and other financial institutions offer home equity loans.

HELOC for debt consolidation

A HELOC is a revolving line of credit you can get if you have accumulated a minimum amount of equity in your residence (usually need at least 20% equity built up to be eligible for a HELOC). With a HELOC, you have a draw period, commonly spanning the line of credit’s initial 10 years. Over this phase, you can extract money (home equity) from your line of credit any time you want so long as you don’t exceed your set credit limit.

Within the draw period, you are only required to make minimum payments on any owed interest for the funds you elect to borrow. Borrow zero dollars and you will owe nothing (unless your lender assesses an inactivity fee). After your draw phase concludes, you aren’t allowed to borrow additional cash unless your lender authorizes a HELOC renewal.

The next phase is the repayment phase, often lasting 10 to 20 years, over which time you must pay back your owed balance.

Cash-out refinance for debt consolidation

With a cash-out refinance, you replace your current primary mortgage loan with a new larger mortgage loan. You take cash out at closing based on the difference in dollars between these two loans (subtracting any closing costs).

You can choose a fixed rate of interest or an adjustable-rate mortgage (ARM). But many people don’t pull the trigger on a cash-out refi unless the interest rate is less than their current mortgage loan’s interest rate.

Which is the best option?

Picking the best home equity vehicle for debt consolidation will depend on your particular financial situation and other criteria.

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“First, determine how much debt you want to consolidate and the interest rates on your current loans. This will help you determine whether a home equity loan, HELOC, or cash-out refi will offer a better interest rate and terms for your specific situation,” Silvermann advises.

Next, consider your monthly cash flow and figure out how much you can afford to pay every month. This can help you decide between a home equity loan or cash-out refinance with a fixed payment schedule or a HELOC with a variable payment schedule.

“Also, ponder your long-term financial goals. A cash-out refinance may be a good option if you want to lower your interest rate and save money over the life of your loan,” he continues. “But it may involve higher closing costs and lengthen the term of your loan versus the other options, which may not align with some of your objectives.”

Hall points out that a home equity loan is usually a stronger option if you need a fixed amount of money immediately upfront, have a steady income, and have an orderly budget you can stick to.

“A HELOC is a good choice if you need extra flexibility and envision requiring additional funding in the future. But the variable interest rates can raise your costs significantly. And a cash-out refinance is a great option when you strictly want to consolidate debt, particularly when seeking to lower your interest rate,” Hall says.

Just be aware that it’s doubtful you’ll find a lower rate today than the current rate you pay for your fixed-rate mortgage.

The bottom line

For the best results and to minimize your risks, consult closely with an experienced lending professional who can guide you through your different financing choices.

You may also want to contact a certified financial planner, personal finance expert, and/or tax professional for more in-depth advice on why, when, and how to consolidate your debt.

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What happens when you take equity out of the house?

When you tap into your home’s equity, you liquidate that equity in the form of cash given to you at closing on a home equity loan or cash-out refinance, or during the draw period of a home equity line of credit. Cashing out equity means the difference between your home’s current market value and your outstanding primary mortgage balance will be less; in other words, you’ll pocket less profit when you sell your home unless your home equity financing is paid off.

Can I use home equity to pay off debt?

Yes, you can use a home equity loan, a home equity line of credit (HELOC), or a cash-out refinance mortgage to liquidate home equity in the form of cash that can be used to pay off your other debts, such as credit card bills, personal loans, and auto loans.

What is the downside of a home equity loan?

The biggest disadvantages of taking out a home equity loan for debt consolidation are that you will pay upfront closing costs and fees that can add up to 2% to 5% of the loan, and you must use your home as collateral for the loan; that means you risk foreclosure if you cannot repay your home equity loan debt.

Erik J. Martin
Authored By: Erik J. Martin
The Mortgage Reports contributor
Erik J. Martin has written on real estate, business, tech and other topics for Reader's Digest, AARP The Magazine, and The Chicago Tribune.
Paul Centopani
Reviewed By: Paul Centopani
The Mortgage Reports Editor
Paul Centopani is a writer and editor who started covering the lending and housing markets in 2018. Previous to joining The Mortgage Reports, he was a reporter for National Mortgage News. Paul grew up in Connecticut, graduated from Binghamton University and now lives in Chicago after a decade in New York and the D.C. area.