When does it make sense to use a home equity loan to pay off debt?

If you’re a homeowner, you may have a tool at your disposal that can help you manage your budget, lower the cost of your debt, and set a firm date for payoff. That tool is your home. 

It can be hard to envision being debt-free. Even more so if all you can do is keep up with the minimum payments on multiple high-interest debts like credit cards. Here’s how a home equity loan could be a smarter way to get your debt under control. 

Four benefits of using a home equity loan to pay off debt

A home equity loan or home equity line of credit—sometimes called a second mortgage—is a way to turn your home’s value into available funds, without selling the home.

You can use a home equity loan to pay off multiple other debts. Going from many monthly payments down to one can simplify your finances and help you budget more efficiently. 

There are a few other benefits to using a home equity loan to consolidate your debts: 

Lower interest rate

Home equity loans tend to cost less than other kinds of loans, like credit cards and personal loans. That’s because there’s a difference between secured and unsecured loans. For a secured loan, you pledge something valuable (like your home) as a guarantee that you’ll repay the loan. This guarantee lowers the lender’s risk of loss, so they usually charge a lower interest rate for the loan. 

For an unsecured loan, on the other hand, you’ll qualify based on your credit score and financial situation. There’s nothing of value that provides a safety net for the lender, so the interest rate will usually be higher compared to similar secured loans.

With a home equity loan, the lower interest rate can help you save money over the life of the loan.

Lower monthly payment

Some borrowers end up with a monthly home equity loan payment that’s lower than the total of all the payments they were making toward the smaller debts.  

If you’ve been facing budget struggles, that lower payment can give you some breathing room for other priorities and expenses.

Earlier payoff

If you consolidate credit card debts with a home equity loan and make a monthly payment that’s bigger than the minimum payments you were making on your credit cards, you could pay off your debts a lot faster and spend less on interest overall.

Fixed monthly payment

When you use a home equity loan to pay off your debt, you get a fixed monthly payment, so you know exactly how much to budget for each month. That predictability can give you peace of mind. Plus, you also know when the total debt will be paid off because you’ll know the loan’s repayment period (that’s called the loan term) when you get the loan. 

In contrast, credit cards have varying monthly payments that are based on your balance and an interest rate that changes. If you only pay what you are required to pay, your payoff date will be very, very far into the future.

Which debts should you pay off with a home equity loan? 

Use a home equity loan for debt consolidation if doing so helps you get a handle on your finances, lower the cost of your debt, or both. 

Some types of debt that might be good candidates for debt consolidation with a home equity loan include:

• Credit cards. The average credit card interest rate topped 20% in the first quarter of 2023 (and some go much higher). Home equity loan interest rates are lower. Using a lower-rate home equity loan to pay off those credit cards can reduce how much interest you pay. Also, credit card rates are variable, which means they can (and do) go up sometimes. Borrowing against your home equity at a fixed rate protects you from fluctuating interest rates.  

• Personal loans. If you have personal loans, it might make sense to pay these off with a home equity loan. You might be able to lower your interest rate or simplify your finances in a way that helps you keep your head above water. Keep in mind, though, that personal loans are designed to be paid off within about five years, and home equity loans are designed to be paid off in 10 to 30 years. Taking a long time to pay could increase your overall cost, even if you get a lower rate. 

• Payday loans. A home equity loan might be a way to break free from the crushing cost of high-cost short-term loans. Payday loan interest rates tend to run from 36% to 650%, depending on where you live. Home equity loan rates typically start at about 10%. 

Review the interest rates and the monthly payment amounts on your current debts, and compare those to the rate and monthly payment amount you might qualify for with a home equity loan. Do this by talking to a home equity lender who can give you a rate quote without hurting your credit score. 

How do you qualify for a home equity loan to pay off debt?

Qualifying for a home equity loan to pay off debt depends on how much equity you have in your home, your credit score, and your income.

Equity is a big factor in how big of a loan you can get. To calculate your equity, subtract how much you owe on your home from its market value.

For example, if you currently owe $150,000 on your home, and the market value of your house is $225,000, you have $75,000 in equity. 

However, most lenders won’t allow you to borrow that entire amount. It’s common for lenders to limit your total debt to 80% of the home’s value. In this case, the total debt including your mortgage would be capped at $180,000, so you could borrow another $30,000 to consolidate your other debts.

Credit score is another factor. If you’re using at least half of the money for debt consolidation, you can apply with a credit score of at least 640. If you have a higher credit score, you might qualify for a lower interest rate.

Your income tells the lender whether you can afford the payment on a new loan. You’ll need to meet the lender’s debt-to-income (DTI) requirements. DTI is how much of your pre-tax income goes to housing and debt payments. If you earn $6,000 per month before taxes and you pay $2,200 on your mortgage, car loan, student loan, and credit card, your DTI is 37%. In other words, 37% of your income goes to housing and debts. Most lenders limit DTI to about 45%, and that includes the payment on the loan you’re trying to get. 

These aren’t hard and fast rules. Home equity loan lenders have some flexibility. For instance, if your credit score is higher, they might allow a higher DTI. 

When is it a good idea to use a home equity loan to pay off debt?

The interest rate is a big consideration, especially if you’re struggling to pay down high-interest credit cards. A home equity loan could bring down the cost of your debt while you pay it off.

If you have a large amount of debt—more than can be handled with a credit card balance transfer or debt consolidation personal loan—a home equity loan might be a good choice. If you have enough equity, home equity loans typically have higher loan limits than other kinds of loans.  

A home equity loan also might be a good idea if you can get a more manageable payment. A lower monthly payment might help you avoid falling behind on your bills.  

Last, having a set payoff date can bring you some comfort. Credit card debts are set up to linger indefinitely (and rack up interest). A home equity loan will have a fixed payment amount calculated to completely pay off your debt by the end of the loan term.

Read more: Pros and cons of home equity loans

What are some of the drawbacks of using a home equity loan to pay off debt?

While using a home equity loan can make sense, there are some risks to be aware of:

• Closing costs. There are usually fees associated with getting a home equity loan, adding to the cost. It’s not uncommon to pay closing costs equal to 2-5% of the loan amount. However, the interest savings might make up for the loan fees.

• Might extend the debt. If you pay off shorter-term debts with a long-term loan, you could pay more in interest. Look for a home equity loan that can be repaid in 10-15 years. 

• Potential to run up more debt. One of the dangers of any debt consolidation is that it doesn’t change your habits. If you take a loan to pay off your credit cards, and then you charge the cards back up, you could end up in worse debt down the road.

If you’re not sure whether you’ll qualify, or whether a home equity loan is right for your situation, ask for a free evaluation from a professional loan advisor.