When it comes to paying off credit card debt, compounding interest rates can make repayment feel like an uphill battle. If you are a Canadian homeowner looking to get out from under your credit card debt, you may be eligible to use a home equity loan to pay off your balance.
Is a home equity loan the right choice for you? In this guide, we cover the basics of paying off debt with a home equity loan as well as the associated benefits and risks.
What is a Home Equity Loan?
A home equity loan allows you to borrow money against the equity you currently hold in your home. Equity refers to the portion of your home you have paid off and fully own. It is the difference between the price of your home and the amount you still owe on your mortgage. For instance, if your house is worth $1 million, but your mortgage is still worth $800,000, you only have $200,000 of equity. If you were to sell your home right now for $1 million, you would only receive $200,000. The other $800,000 would go towards repaying your mortgage loan.
When you take out a home equity loan, the bank or credit union you are borrowing from will pull out a percentage of your equity and loan it to you. Homeowners with extensive credit card debt may use a home equity loan to pay off their debt and then slowly pay back the home equity they borrowed initially.
Is a Home Equity Loan Different Than a HELOC?
There are two ways to access the equity in your home: home equity loans and home equity lines of credit (HELOC). However, the two are certainly not the same.
Under HELOCs, you are opening a line of credit tied to your equity. You can borrow, spend, and repay the money tied to a HELOC the same way you might use a credit card. The HELOC will usually have a cap determined as a percentage of your current equity. This percentage can vary based on your credit score and financial profile.
Unlike a HELOC, a home equity loan involves borrowing a lump sum of cash. In many cases, this makes it the more appropriate choice for significant debt consolidation and repayment.
Paying Off Credit Card Debt with a Home Equity Loan: Benefits and Risks
Before deciding to take out a home equity loan, it is crucial to consider the benefits and risks you may incur.
The Benefits of a Home Equity Loan
A home equity loan can significantly benefit homeowners struggling to repay their credit card debts. Here are some of the major advantages:
- Lower Interest Rate: when you pay off your credit card debt with a home equity loan, you effectively lower your interest rate. The average home equity interest rate is just one-fourth of the average credit card interest rate. Reducing your interest costs can save you thousands in the long run.
- Debt Consolidation: if you have multiple credit cards that need to be repaid, a home equity loan allows you to pay them all off at once. Following this repayment, you will consolidate your monthly debt payments from multiple individual card payments into one home equity loan payment. Consolidating your debt will also further reduce your interest.
The Risks of a Home Equity Loan
While a home equity loan can be an excellent option for you, it is also important to consider the risks before making a decision. Here are some potential drawbacks:
- Your Home as Collateral: the biggest drawback of a home equity loan is that your home is used as collateral—if you cannot repay the principal amount within the specified period, you risk losing your house. However, if you approach your loan realistically and budget your payments ahead of time, the chances of this happening are low.
- You May Accumulate More Debt: while a home equity loan can be a great way to repay your credit card debts, it is important to consider your current financial situation. If you are not confident in your ability to repay your home equity loan, you may find yourself in more debt than before.
Alternatives to Paying Off Your Credit Card Debt
If a home equity loan does not sound like the right fit for you, there are a few other options you can consider. Here are a few alternative ways to pay off your credit card debt:
Switch to a Lower-Interest Credit Card
The biggest hurdle when paying off credit card debt is the increasing cost of compounded interest. Interest on credit card payments, especially late payments, compound and can quickly spiral out of control.
Luckily, many credit card companies offer promotions for new clients that can reduce your interest expenses. You may be able to transfer all your debts onto a new credit card that charges 0% interest for the first year and a half. While transferring your debt to a new card will not make it disappear, it does give you more time to catch up on your payments without having to pay substantial interest fees.
Create a Repayment Plan
The sooner you repay your credit card debt, the more money you save. After all, you cannot be charged interest on a loan that has been fully repaid. If you only make the minimum required monthly payments, it will take a very long time to pay off your debt entirely. It is recommended that you budget out your earnings to pay off as much of your credit card bill as you can, as quickly as you can.
Borrow Money From Your RRSP
If you have significant capital in your Registered Retirement Savings Plan (RRSP), you may be tempted to withdraw those funds to help pay off your credit card debts. While this can be a good option if you do not want to put your house up as collateral, withdrawing from your RRSP does come with a few setbacks.
If you are withdrawing from your RRSP, and it is not to purchase your first home or finance your education, you will be subject to a withholding tax upon withdrawal as well as an additional income tax. Despite these restrictions, paying off your debt is often worth the extra cost.
Ask the Professionals
If you are struggling with the decision between a home equity loan or an alternative route, Clover Mortgage can help. Our team is specialized in debt consolidation loans and has access to a vast network of over 50 different lenders. Our team can help you explore your options and determine if a home equity loan is right for you.
Contact Clover Mortgage to schedule a free consultation today!