While many people buy a home while they have other forms of debt kicking around, it’s probably not the best idea.  A house is full of new expenses, from utility bills, new taxes, and regular maintenance and repairs.  These new expenses can stretch your household budget, and having additional debts on the side simply adds to the confusion.

That’s why it seems like a great idea to consolidate all of your debts with a home equity line of credit (HELOC) – but is that really the smart move?

What is Debt Consolidation?

In general, a debt consolidation program is a loan you receive for the total amount of your debts.  So if you owe $2,000 on one credit card, $3,500 on a second credit card, and $500 to something else, you’d get a loan for $6,000 and pay off all three loans completely.  This leaves you with a single loan to pay back (a $6,000 one).

The benefits of doing this are:

  • One Monthly Payment – Since there’s only one loan, there’s only one payment.  It’s easier to pay attention to, easier to track, and harder to forget.
  • Lower Interest Rates – Quite often your credit card payments have an incredibly high interest rate – as high as 30% – but with a consolidation loan you may be able to get a lower overall average interest rate, which always helps.
  • Manageable Monthly Payment – Not only is the payment just one payment a month, you can also negotiate the payment term so that the payment is manageable with your income.  No sense in combining your loans to a single payment only to have that payment be impossible for you to make.

What is A HELOC?

A HELOC is simply a line of credit that is secured by the equity in your home.  Because they’re backed by actual equity (unlike a traditional line of credit), the interest you pay is usually much lower (closer to a mortgage interest rate). 

Once you’ve been approved for a HELOC, there are no conditions on what the money is used for (but there ARE conditions on how you pay it back).

Using A HELOC For Debt Consolidation

Whereas a debt consolidation loan is usually facilitated by a company which specializes in that type of service, what we’re talking about is more of a do-it-yourself approach.

To do this yourself, you would:

  • Buy your home – You obviously need some equity in your home in order to be approved for a HELOC
  • Get approved for a HELOC – It’s a misconception that you have to get your HELOC through the same institution which provides your mortgage.  Check out our HELOC rates here.
  • Pay off your loans – Using the money from your HELOC, pay off all of your outstanding debts

That’s it!  Now you start paying back your HELOC, which will have a minimum monthly amount. With only two debts (your mortgage and the HELOC), your financial situation should be much easier to manage.

Advantages To This Method

As we mentioned, interest rates are very low for a HELOC loan.  At the time of this writing, rates between 3.50% and 3.75% are common.  This is MUCH less than a credit card or student loan.

As well, you won’t be hounded by creditors – you only owe money to your bank and HELOC provider.

Disadvantages And Dangers

The biggest danger to this method is that your loan is now secured by your home.  If you default on this payment, your creditor can and will take your home from you.  If you do find yourself falling behind, always be proactive about what’s going on.

Call your lender, explain the situation and come up with a plan to get back on track.  Your bank doesn’t want your house, and being proactive will buy you much more time and options than ignoring their phone calls.

The last danger is more of a behavioral one.  Too many people figure out how a HELOC can help them and end up justifying extra debts on top of what they have.  “Wow, so we can pay off all of our debts at once – why don’t we go ahead and put the new car in there as well since the interest rate is so low”. 

Accruing additional debts just because they all fall under the same umbrella is foolish.  This is not free money and shouldn’t be treated as such.

Used responsibly, however, it can definitely contribute to your family’s overall financial health and we certainly recommend it.