Creditor Debt vs Home Equity – A Balancing Act
If you’re like most people, the biggest check you write every month is for your mortgage payment. Each month, some of that money contributes to your equity in the property, and as time goes by, more and more of that house is actually yours. However, if you have fallen into a situation where you have significant levels of creditor debt, then accessing some of that equity through a loan or line of credit can be a lifesaver. The money that you get can pay off that high-interest debt, and then you can pay yourself back at a lower interest rate.
People who take out second mortgages to pay off debt do so through home equity loans or home equity lines of credit (HELOCs). You’ll pay more interest on this type of loan than you are on your primary mortgage because the risk associated is higher. Your primary mortgage has to be paid off first in the event of default and foreclosure, and if the sale price is not enough to satisfy both mortgages, it is the second mortgage lender who is left with the shortfall. However, because the home is the collateral on this second loan, the interest rate will be significantly lower in most cases than what you would pay for borrowing through such unsecured sources as credit cards or debt consolidation loans.
However, before you run down to the bank and ask for a second mortgage, ask yourself these questions.
Do you often pay for your household bills with credit cards?
If you subtract monthly expenses from your salary, do you get a negative number?
If you used an equity loan or line of credit to pay off creditors, is there a strong likelihood that you would be amassing more unsecured debt again in the near future?
If your answer to any of these questions is “Yes,” then a home equity loan or line of credit might actually be a bad idea. Because you’re regularly running a budget deficit, you are only going to find yourself in a similar situation a few months from now, as you have to keep borrowing to meet your monthly needs. Before you consider using home equity to pay off your existing debt, you must come up with a plan to bring your budget into the black. That way, you can pay your second mortgage back — if you run into trouble with this home equity loan, you can run into foreclosure proceedings even if you keep paying that primary mortgage back.
If you answered “No” to all of those, then a home equity loan or HELOC can help you out. Maybe you had to pay for an unexpected medical procedure or you were out of work for an extended time and had to borrow some money from an unsecured lender. You’ve found a job and are doing well now, but that debt is piling up interest. Paying it off now, and paying yourself back at that lower interest rate that comes with a home equity loan, can make a huge difference.
The first step is to find the lowest available interest rate for your home equity loan. Remember that if you’re applying for a loan, you may be subject to finance charges and point charges, but when you look at a HELOC, you’re just looking at an interest rate on the money you are taking out. This means that you should consult as many lenders as you can and do a comparison on the terms of the loan, including any closing costs, the interest rate, the term and your monthly payments. Make sure that you don’t have much (if any) of a penalty for prepayment, because the idea is to help you get out of debt as soon as possible. Also ask if you’re going to be having to pay for credit insurance.
If you’re taking out a home equity loan, you’ll get a lump sum at closing, and the repayment term can vary. You’ll have equal monthly payments that will satisfy the loan over time, much like your primary mortgage does. Some lenders let you borrow as much as the amount of equity that you have remaining (the estimated value minus your current equity), although others will only let you have up to 90% of the equity combined out of the house, adding the two loan balances together. Remember that you don’t have to borrow the maximum, so don’t let a loan officer talk you into taking out more than you need. If you have a set amount in mind, such as a total of your unsecured debt lines, then the best idea might be a home equity loan that will give you a lump sum in that exact amount. That way you won’t be tempted to use the extra money for something you don’t need — and end up having to pay for that over time too.
HELOCs are a type of revolving credit, sort of like a credit card. Your lender takes a percentage of the difference between your home’s appraised value and the amount you still owe on the primary mortgage and sets up a line of credit in that amount. Other factors in setting the line of credit include your income, other debts and other obligations, as well as your credit report. After you get approval, you can borrow up to that limit, although you generally have to do it in increments rather than taking it all at once. Some lenders will charge you transaction fees or maintenance fees when you draw on it. You generally have a set term and if you don’t make monthly payments, you can end up with a balloon payment at the end. The advantage of this is that you don’t have to take out much at once, and you only get interest charges when you take the money out. This can tempt you to take money out that you don’t need simply because it’s there.
If a home equity loan or a HELOC sounds right for your needs, get in touch with lenders in your community to find the best deal for your needs. Just remember that you need to have a budget that ends up in the positive each month before you start accessing the equity you’ve already bought.