After running through their savings and maxing out credit cards, debt-strapped consumers may feel that they’ve come to a dead end with no other alternative save bankruptcy. However, for some homeowners, the equity in their residences can be the answer to their debt problems.
Because your home is a quantifiable asset to which an enforceable lien can be attached, it can serve as collateral for a debt consolidation loan, which may be difficult to secure otherwise. Debt consolidation is a financial strategy in which the consumer takes out a new loan and uses the proceeds to pay off multiple outstanding loans, such as credit cards, car loans, and students loans. Debt consolidation can be successful if you can qualify for a lower interest rate on the new loan than you were paying on the old loans. If so, your new payment will be less than the combined payments you replaced.
A debt consolidation loan can also reduce your monthly payment by extending the loan term, easing an immediate cash flow problem if you need help paying bills. However, because the extended term can increase the total interest paid over the life of the loan it is not as effective.
“I Need Help Paying My Bills, but I Already Have a Mortgage”
Having a first lien mortgage on your home does not mean you can’t use it for collateral on a debt consolidation loan. If the debt owed is less than the value of the property, you can obtain a second lien mortgage or home equity loan. However, the rules aren’t cut and dry; they vary by state and lender. In some cases, total indebtedness can be limited to 80% of the property’s value; other programs have allowed up to 125% of its value to be borrowed.
Be aware that many lenders have been more cautious as property values have declined. Fannie Mae, the largest guarantor for home loans in the US, and its rival, Freddie Mac, instated a policy requiring lenders to raise equity requirements by 5 percentage points in housing markets that have been hardest hit. Under the new guidelines, borrowers are also restricted from receiving cash from the transactions. The loan proceeds may only be used to pay off an existing first lien, pre-pay interest, or pay transaction closing costs for refinancing within standard loan-to-value ratios in those declining markets.
Lenders have also been “freezing” or reducing home equity credit lines in accordance with a memo issued by the Federal Reserve Board authorizing such actions “if the value of the home declines significantly or, when the lender reasonably believes that you will be unable to make your payments due to a “material change” in your financial circumstances.”
Using Your Home to Consolidate Debt Can Lower Your Tax Bill
Because home mortgage interest is tax deductible (up to $1,000,000 of debt), consolidating non-deductible debts such as credit card debts or auto loans into deductible mortgage debt can generate significant tax savings. But be careful – there are limitations based on the value of your home and how you use the loan proceeds.
Interest paid on a cash-out home equity loan can only be deducted up to the value of the property. So, for example, if you are successful in finding a lender that will loan 125% of the value, you can only deduct the interest paid on 100% of the value. (If you were to use the new loan for home improvement rather than debt consolidation, for example, you could deduct all interest paid up to the $1,000,000 debt limit).
The Risks of Using Your Home to Consolidate Debt
While a home equity loan is great if you need help paying bills, it is not risk free. By consolidating credit card or other unsecured debts into secured home equity debt, you’ve increased the risk of losing your home if your financial situation deteriorates. In a worst case scenario, unsecured debt can be wiped out with a Chapter 7 bankruptcy filing whereas secured creditors have legal right to seize the loan collateral – including your home.
You have also probably extended the time it will take you to pay off your home by attaching more debt to it, which can jeopardize your future retirement, as well as increase the cost of the interest paid. Taking out a home equity loan is an important decision with long-term implications. If you need help paying your bills, carefully weigh all options before choosing a home equity loan.
Is debt consolidation the right financial move for you? Find out which financial situations debt consolidation works best for and what options are available.