Home Equity Loan vs. HELOC: Which is Best for Borrowing Against Your Equity to Pay Down Credit Card Debt?
Credit card debt is a significant financial burden for many Americans. As of July 8, 2024, the average annual percentage rate (APR) for new credit card offers in the United States is 24.84%, according to LendingTree. This marks the highest rate since LendingTree began tracking rates in 2019. Over the past decade, the average APR for credit cards that have been assessed interest has nearly doubled, from 12.9% in 2013 to 22.8% in 2023. With such high-interest rates, consumers are exploring alternatives to manage and pay down their credit card debt more efficiently. Two popular options for tapping into home equity are Home Equity Loans and Home Equity Lines of Credit (HELOCs). Safe Money Lady™ will explore both options, comparing their advantages and drawbacks, and provide an in-depth analysis of which may be best for borrowing against your equity to pay down credit card debt.
Understanding Home Equity Loans
A Home Equity Loan, often referred to as a second mortgage, allows homeowners to borrow a lump sum of money against the equity they have built up in their homes. This loan is secured by the home itself, which means that if the borrower defaults, the lender has the right to foreclose on the property. Home Equity Loans typically have fixed interest rates and fixed repayment terms, which can range from 5 to 30 years.
Advantages of Home Equity Loans:
Fixed Interest Rates: One of the primary benefits of a Home Equity Loan is the fixed interest rate. This provides predictability in monthly payments, making it easier to budget and plan for repayment.
Large Lump Sum: Home Equity Loans are ideal for borrowers who need a substantial amount of money upfront, as the entire loan amount is disbursed at once.
Potentially Lower Rates: Compared to credit card interest rates, Home Equity Loans often offer lower rates, which can result in significant savings over time.
Drawbacks of Home Equity Loans:
Risk of Foreclosure: Since the loan is secured by the home, failure to make payments can lead to foreclosure.
Closing Costs: Home Equity Loans typically come with closing costs, which can range from 2% to 5% of the loan amount. These costs must be factored into the total expense of the loan.
Fixed Amount: Once the loan is taken out, the borrower cannot increase the loan amount if additional funds are needed later.
Understanding HELOCs
A Home Equity Line of Credit (HELOC) operates more like a credit card than a traditional loan. Borrowers are given access to a revolving line of credit based on their home equity and can draw from this line as needed, up to a predetermined limit. HELOCs usually have variable interest rates, and the repayment terms can vary.
Advantages of HELOCs:
Flexibility: HELOCs provide flexibility in borrowing. Borrowers can take out money as needed and only pay interest on the amount they draw.
Lower Initial Costs: HELOCs often have lower initial costs compared to Home Equity Loans. Some lenders may waive certain fees, making it more affordable to set up.
Revolving Credit: As borrowers repay the principal, the credit line is replenished, allowing for repeated borrowing without needing to apply for a new loan.
Drawbacks of HELOCs:
Variable Interest Rates: The interest rates on HELOCs are typically variable, which means they can fluctuate based on market conditions. This can lead to unpredictable monthly payments.
Risk of Over-borrowing: The flexibility of a HELOC can lead some borrowers to take out more money than they can afford to repay, potentially leading to financial difficulties.
Draw Periods and Repayment Periods: HELOCs have specific draw periods (usually 5-10 years) during which the borrower can take out money, followed by a repayment period (typically 10-20 years). During the repayment period, borrowers must pay back both principal and interest, which can significantly increase monthly payments.
Comparing Costs and Savings
To determine which option is best for paying down credit card debt, it's essential to compare the costs and potential savings associated with Home Equity Loans and HELOCs. Let’s break down the math with a hypothetical scenario:
Scenario:
Home equity available: $100,000
Credit card debt: $50,000
Average credit card APR: 24.84%
Home Equity Loan interest rate: 6%
HELOC interest rate (variable): Starts at 5.5%
Home Equity Loan Calculation:
Assuming a 10-year repayment term for the Home Equity Loan:
Loan amount: $50,000
Fixed interest rate: 6%
Monthly payment: Calculated using the formula for a fixed-rate mortgage
M=P×r×(1+r)n(1+r)n−1M = \frac{P \times r \times (1 + r)^n}{(1 + r)^n - 1}M=(1+r)n−1P×r×(1+r)n
Where:
MMM = monthly payment
PPP = principal amount ($50,000)
rrr = monthly interest rate (6% / 12 months = 0.005)
nnn = number of payments (10 years x 12 months = 120)
M=50,000×0.005×(1+0.005)120(1+0.005)120−1≈555.10M = \frac{50,000 \times 0.005 \times (1 + 0.005)^{120}}{(1 + 0.005)^{120} - 1} \approx 555.10M=(1+0.005)120−150,000×0.005×(1+0.005)120≈555.10
Total interest paid over the life of the loan: 555.10×120−50,000=16,612555.10 \times 120 - 50,000 = 16,612555.10×120−50,000=16,612
HELOC Calculation:
Assuming the borrower uses the entire $50,000 credit line and pays it back over 10 years with a starting interest rate of 5.5% (variable):
For simplicity, we’ll calculate the interest for the first year and adjust for potential rate increases:
Year 1 interest: 50,000×0.055=2,75050,000 \times 0.055 = 2,75050,000×0.055=2,750
Monthly interest payments: 2,75012≈229.17\frac{2,750}{12} \approx 229.17122,750≈229.17
If the interest rate remains constant (which is unlikely with a variable rate, but for this example, we'll assume no increase for simplicity): Total interest for 10 years: 2,750×10=27,5002,750 \times 10 = 27,5002,750×10=27,500
In reality, the interest amount would vary, and the total interest paid could be higher or lower depending on rate changes.
Comparing the Total Costs:
Home Equity Loan:
Total paid (principal + interest): $50,000 + $16,612 = $66,612
HELOC:
Total paid (principal + estimated interest): $50,000 + $27,500 = $77,500
Analyzing the Results:
From the calculations above, it's clear that the Home Equity Loan has lower total costs ($66,612) compared to the HELOC ($77,500). This is mainly due to the fixed interest rate of the Home Equity Loan, which offers stability and predictability in payments. However, this does not account for the potential increase in HELOC rates over time, which could further widen the cost gap.
Factors to Consider When Choosing Between Home Equity Loan and HELOC
While the math indicates that a Home Equity Loan may be more cost-effective for paying down credit card debt, there are several factors to consider:
Interest Rate Trends: If you anticipate interest rates rising significantly in the future, a Home Equity Loan with a fixed rate might be more advantageous. Conversely, if you believe rates will stay low or decrease, a HELOC could offer more savings.
Borrowing Needs: If you need a large sum of money upfront, a Home Equity Loan is suitable. However, if your borrowing needs are more sporadic or you anticipate needing different amounts at different times, a HELOC provides greater flexibility.
Repayment Discipline: A Home Equity Loan's fixed monthly payments can instill discipline in repayment. In contrast, a HELOC requires careful management to avoid over-borrowing.
Costs and Fees: Consider all associated costs, including closing costs, annual fees, and potential early repayment penalties.
Case Study: Evaluating Real-Life Application
Let’s consider a real-life example to illustrate how a borrower might choose between a Home Equity Loan and a HELOC.
Case Study:
Jane is a homeowner with $80,000 in home equity. She has accumulated $40,000 in credit card debt with an average APR of 24.84%. Jane is exploring her options to pay down this high-interest debt using her home equity.
Home Equity Loan Option:
Jane takes out a Home Equity Loan for $40,000 at a fixed interest rate of 6% with a 10-year repayment term.
Monthly payment: $444.08
Total interest paid: $13,289.60
Total cost: $53,289.60
HELOC Option:
Jane takes out a HELOC with a credit limit of $40,000, starting with a 5.5% variable interest rate.
First-year interest payment: $2,200
Estimated total interest over 10 years (assuming no rate change): $22,000
Total cost: $62,000
Jane evaluates the total costs and decides that the Home Equity Loan is the better option for her, as it offers a lower total cost and fixed monthly payments, providing her with financial stability and predictability.
When deciding between a Home Equity Loan and a HELOC to pay down credit card debt, borrowers must consider the total costs, flexibility, interest rate trends, borrowing needs, repayment discipline, and all associated fees. By carefully evaluating these factors and performing the necessary calculations, homeowners can make an informed decision that best suits their financial situation.
Best regards,
Sharon Ben-David
Your Safe Money Lady™
Protecting Your Nest Egg, Inc.
Phone: (954) 261-5200
