If you have existing debts such as credit cards, personal loans, store cards and more, you’re probably working hard to pay this credit back. Using home equity to consolidate and pay off those existing debts may be the most advantageous method for you.
Work smarter not harder – and read this guide explaining how you could use a home equity loan to pay off your debt. It’s always advised to seek free and personal debt advice to find the best way to clear your debts, such as the services offered by Step Change.
What is home equity?
Home equity is a term used to describe how much money you have in the home you are in the process of buying through a mortgage. It is calculated by taking the value of your home in today’s market – not what you bought it for as the value may have increased or decreased – and then subtracting the outstanding amount on your current mortgage.
For example, if you have a house worth £200,00 and you have £100,000 left to pay on the mortgage, you will have £100,000 of home equity (£200,000 – £100,000). If you own the home outright with no mortgage to pay, the equity in your home will be the same as the property’s market value.
What is a home equity loan and HELOC?
A home equity loan and a home equity line of credit (HELOC) are both methods of accessing credit based on your home equity. They usually provide lower interest rates than unsecured personal loans, but they do put your home at risk. Neither of them is the same as a second mortgage, although there are some similarities.
A home equity loan is a type of loan that uses the amount of equity to determine how much you can borrow while simultaneously using the equity as collateral in the event you do not keep up with monthly payments. A home equity loan is best understood with an example. If you have £100,000 equity then a lender could grant you a fixed-rate loan up to around 80% of this value (£80,000). Using a home equity loan comes with a risk because you could lose your home if you miss monthly payments.
A home equity line of credit (HELOC) works in a similar way with some key differences. Instead of receiving the money as a lump sum, it allows you to borrow money over many years as and when you need it, officially known as the draw period. Once the draw period ends, the homeowner then makes a monthly payment with a variable interest rate until it is paid off.
How much can you borrow?
Lenders providing home equity loans and HELOCs will usually allow you to borrow around 80% of your home equity and may need to value your home to determine the accurate amount of equity you have. For example, if you had £75,000 home equity then you could get a loan or line of credit up to £60,000. This is far more than what would be possible using a personal loan.
The reason you can only borrow up to 80% of the equity available is that the lender needs to create a buffer in case the property value decreases over time, and consequently, the equity in your home decreases as well. All parties want to avoid a situation where you have borrowed more than the home is worth.
Can you take equity out of your home to pay off debt?
You can use a home equity loan to pay off other debts, including to pay off an existing mortgage or for debt consolidation purposes.
Home equity loans can be used for a wide range of purposes, such as:
- Home renovation projects
- Education and medical bills
- Helping family members with finance
- Pay off a mortgage
- Pay off another debt
- Debt consolidation
You can use a home equity loan to pay off a remaining mortgage balance, which would be beneficial if the loan has lower interest than the mortgage. This may be because you were not able to access the better mortgage rates at the time you took out the mortgage.
This is one example of using home equity to pay off a debt, but it could apply to other debts like personal loans. However, it will depend on the amount of the debt because home equity loans usually come with a minimum amount of £10,000 – not always!
It’s also possible to consolidate debt from multiple sources using a home equity loan. We discuss more about this further down our guide.
Can you use a home equity loan to pay off credit card debt?
Taking out a home equity loan and paying off a credit card debt is possible, but it will depend on the extent of the credit card debt. Most lenders will only grant home equity loans with a minimum balance of £10,000 and you’ll probably not need such a large sum to pay off a single credit card.
Paying off multiple credit cards could make a home equity loan more suitable, otherwise, a home equity line of credit is an alternative option. A HELOC allows you to access cash when you need it over the drawing period, so you could access a smaller amount to pay off a sole credit card and use the rest of the HELOC balance as and when needed.
What is the downside of home equity loans?
The biggest downside to using a home equity loan or HELOC is that the equity in your home is used as collateral. This allows the lender to force you to sell your home if you stop making monthly repayments. The trade-off is that these options come with low interest rates in comparison to other personal finance options.
Another downside of a home equity loan is closing costs. The closing costs are additional fees at the end of the agreement. At the time of writing, standard closing costs range from 2-5% of the overall loan balance. If you were to borrow £20,000 in a home equity loan then the closing costs could range from £200 to £500.
How home equity works for debt consolidation
Debt consolidation is when you take out new credit and use the money to pay off multiple other debts. When this is done you still owe the same amount of money, but instead of owing multiple lenders and having to budget for various monthly payments at different times, you pay just the new lender once each month. It makes managing your money and debt easier.
But when you consolidate debts you don’t just want to move the debt balance to one location, you want to grab a better repayment deal in the process. This means finding a new source of credit large enough to repay existing debts with a lower interest rate than you are paying on current credit and debts. This shouldn’t be too difficult if you already have high-interest debt. If the new interest rate is higher than the interest rates currently payable, debt consolidation will not be worthwhile.
A home equity loan can potentially be one of the best ways to achieve debt consolidation. It allows you to access large amounts of credit in a lump sum and the money is allowed to be used for this purpose. Moreover, as you are somewhat securing the cash against your house, it has a better chance of providing a lower interest rate than what you’re currently paying on an unsecured personal loan, credit card debt etc.
Once you receive the loan you use it to pay off existing debts and start making repayments on the new loan instead.
The pros and cons of a home equity loan for debt consolidation
There are many different methods to consolidate debts, so it’s important to understand the pros and cons of each – along with debt advice – before choosing your method. Below you can find the pros and cons of using a home equity loan to pay off multiple debts. These pros and cons are for this reason only, rather than the general pros and cons of using home equity loans.
- Lower interest rates – although not guaranteed, home equity loans typically have a lower interest rate than other debt consolidation credit. This is because you are using your home equity as collateral within the agreement. The lender will feel more comfortable that they can recover their money and can therefore offer a better interest rate compared to an unsecured personal loan. This is key when deciding whether to consolidate debts or not.
- Unrestricted purpose – home equity loans are not restricted in their purpose, meaning you are allowed to use them to consolidate debts. Moreover, you could use some of the money to consolidate and part of the money for other purposes, such as home renovations. Alternative debt consolidation credit may not allow this.
- Closing costs – earlier we mentioned how ending a home equity loan includes a fee of around 2-5% of the total loan value. This fee could make home equity loans less desirable and not as good as some other options. It could even wipe out any savings you make within the interest payments. The specifics of this will be determined by the actual fees and the amount you need to borrow for debt consolidation.
- High minimum credit – another potential con is that the lender is only willing to lend more than you need. Many home equity loans have minimum balances of around £10,000. If you do not need this much you will be overborrowing – at a cost – which again would make debt consolidation using this method unworthwhile. And if you did need a significant sum, other debt solutions may be more beneficial, such as an Individual Voluntary Arrangement.
Will I qualify for a home equity loan?
Each application is judged on its own and there is no way to say 100% you will be approved for a home equity loan. If you have a good credit score then you are more likely to be accepted.
You’ll only be able to apply for a home equity loan if you meet the primary eligibility criteria, usually that you are at least 18 with a regular income and plan to live in the UK for at least six months of every year.
Once you apply, the lender will assess your credit score and make a decision accounting for all the information provided.
Is it smart to use home equity to pay off debt?
It can be smart to pay off your existing debts with a home equity loan. But this method does put your home at risk and there are lots of factors to consider. It’s only smart if it’s the right choice for you, which means taking your time, doing research and comparing loan options accurately.
Alternative ways to consolidate debts
Here are some of the alternative ways you can consolidate debts. Methods that require you to not own a home have been left out:
- Remortgaging – this could help you consolidate debts in a similar way to a home equity loan.
- Debt consolidation loans – these are usually unsecured loans specifically to consolidate debts.
- Balance transfer credit card – a balance transfer is when you move the balances of multiple credit cards to a new credit card that allows this to happen. It’s a good alternative if you only wish to consolidate credit card debt.
- Individual Voluntary Arrangement – a debt solution that allows you to group all repayments together and potentially write off some of your debt after six years.
Should you use home equity to pay off debt?
There is no one-answer-fits-all approach to debt consolidation and home equity loans. If you are considering this option then you are urged to seek free debt advice first. Step Change, National Debtline and Citizens Advice are just some of the groups willing to provide personalised debt advice and support for these purposes. Make the most of them so you don’t make costly mistakes!
And read our debt consolidation guide to learn more about ways to pay off your credit card payments, personal loans, store cards and other arrears.