Using Home Equity to Reduce Bad Debt

Used properly, home equity can be very useful for homeowners wanting to get out of debt. What? You say I should go into debt to get out of debt?  Well, actually, Yes! If done correctly, leveraging debt can work to your advantage. Now this doesn’t necessarily work for everyone and depending on your credit situation it may not be an option.

If you are considering leveraging equity to pay off bad debt, there are several options you should consider before taking this big step. Among others, some options include taking out a 2nd mortgage on your home-sweet-home, equity refinance, Home Equity Line of Credit (HELOC) and an unsecured LOC.  We’ve touched on the advantageous and disadvantages of 2nd mortgages in a previous article (Going Into Debt to Get Out of Debt: The Dangers of Second Mortgages), so here we will focus on equity Refinancing.

Before we can talk about debt leveraging, though, we need to have a basic understanding of ‘good’ versus ‘bad’ debt.  ‘Good’ debt is investing debt, or using borrowed assets, used to purchase items that appreciate or goes up in value. Examples would include using borrowed money to invest in real estate, starting a business, or replacing higher interest rates on credit cards with lower rate options.

Using a home equity line-of-credit (HELOC) with a prime interest rate to pay off a credit card balance currently charging 19% interest is considered ‘Good’ debt. ‘Bad’ debt, on the other hand, is using borrowed money to buy a depreciating asset, or anything that loses value. Examples of this is borrowing money to purchase a car that is worth considerably less hours after you purchase it.

Purchasing anything using a high interest rate credit card and not paying the balance off in full every month is an example of bad debt. As the interest charges mount, you end up paying more for the product than the original purchase price and to make matters worse, the accumulated interest compounds monthly until you pay off your balance in full.

Now that we’ve got that straight, properly utilizing home equity (the difference between the market value of your home and the unpaid mortgage balance) is a great way to leverage good debt. Refinancing your home to reduce monthly payments with a lower interest rate or to access cash that was locked in as equity to pay off bad debt can be referred to as good debt.

Of course, your home needs to have sufficient equity first in order to do this. To estimate your homes current market value, lenders will require that an appraisal first be completed on your home.

The difference between the homes appraised value and your current mortgage amount (i.e., Loan-to-Value) is the amount of total equity in your home. In a mortgage refinance, though, you are restricted by the lenders acceptable loan-to-value (LTV) tolerance, based on its acceptable risk appetite.

Most lender limits your equity payout to 90% or less of the homes appraised value. So your available equity is the difference between the current mortgage balance and 90% of the current appraised value of your home.

Now with any loan negotiation, it only makes sense to refinance your home if it puts you ahead. If you currently cannot make the payments and the refinance doesn’t lower your payments, only provides a lump of cash, it may not be worthwhile. This is just stalling the inevitable and may require some tough decisions on your part.

Part of the lenders job will be to assess your family budget to ensure you are not spending too much of your income on your mortgage. Beyond the lenders calculations, though, you should always make sure that your own budget is sufficient to absorb any new costs and payments that result from your refinance. A qualified financial planner or credit counsellor can assist in helping you determine your personal budget.

In future articles we will discuss other equity options available to homeowners, including Home Equity Line of Credit (HELOC) and unsecured LOCs.

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