Using Your Home's Equity to Consolidate Debt

Mounting debt is a harsh reality for millions of consumers hurt by today's turbulent economic climate.

Many of those facing seemingly insurmountable debt are scrambling to find a way out from underneath their mountain of bills - some even consider bankruptcy.

Fortunately, there is a possible solution available to many individuals who are drowning in debt. Those looking for a way out can tap into the equity in their homes as a means to consolidate that debt.

Two Ways to Use Your Home's Equity

There are two primary methods commonly utilized to consolidate debt by leveraging the equity in one's home: a home equity line of credit and a home equity loan.

A home equity line of credit and a home equity loan work in a similar fashion. Each option is determined based on the value a person owns in his or her home.

When one applies for a home equity line of credit or a home equity loan, the lender starts with the current appraised value of the borrower's home. Once the appraised value is established, a percentage of that value - typically 75 percent - is used to determine the maximum line of credit or loan amount.

To determine the actual amount of the line or credit or loan, the lender then will subtract the amount the borrower still owes on his or her mortgage from the adjusted appraised value of the home.

Take for example a borrower who owns a home that is appraised at $200,000 with a $120,000 mortgage. In this scenario, the adjusted appraised value of the home would be $150,000 (75 percent of $200,000). With a $120,000 mortgage, the maximum amount the borrower would be able to secure for a home equity line of credit or loan would be $30,000.

Home Equity Lines of Credit versus Home Equity Loans

While home equity lines of credit and home equity loans work in very similar ways, these options do offer unique features that set them apart from each other. It is important for consumers to understand these differences in order to select the best option to meet their financial needs.

With a home equity line of credit, the borrower is able to draw money from the line of credit as needed, much like a credit card. This feature is especially convenient for borrowers who do not know how much money they will need up front.

Then, as the borrower repays what was previously withdrawn, he or she is able to redraw from the line of credit again and again.

In contrast, a home equity loan, also referred to as a second mortgage, is a fixed amount of money that is repaid over a specific period of time. Funds are received in one lump payment once the loan is finalized. The borrower then makes predetermined monthly payments, much like a regular mortgage.

Another key difference between a home equity line of credit and a home equity loan is the annual percentage rate, or APR. For home equity lines of credit, the APR typically varies from month to month. For a home equity loan, however, the APR generally is a fixed rate determined when the loan is secured.

A benefit for both options, though, is the APR for both home equity lines of credit or a home equity loans is typically much lower than interest rates associated with credit cards and unsecured personal loans.

Another similar benefit associated with home equity lines of credit and home equity loans is the interest paid on each is tax deductable in most cases.