Not everyone has the good fortune of having their finances just as they need them to be when unforeseen expenses appear on the horizon. Fortunately, it has become easier to utilise credit for dealing with these situations. But credit has a downside, too. If you’re overly reliant on loans and credit, you might eventually find it hard to keep track of all the loans you’ve taken up. If you're in this situation, consolidating your debts into one loan could be a solution to consider. Typically, people take out personal loans or home equity loans to consolidate their debts.
WARNING - Consider your own circumstances, or obtain advice, before you act on the general information contained in this article.
So, what is a home equity loan?
Home equity loans let you capitalise on the equity you have in your existing home. They enable you to utilise the capital gains of your house without needing to sell it. Your home equity is essentially the current value of your property minus the mortgage you owe.
For instance, consider that you own a house with a current market value of $500,000 of which you owe $150,000. By using the formula given above you will arrive at a figure of $350,000. This is the amount of equity you have in your home.
One thing you’ll need to remember is the fact you will not be able to use all the available equity you have in the property. Lenders usually offer 80% of the value of the property minus the amount you owe on it. In case you require more than this 80%, consider taking out Lender's Mortgage Insurance (LMI).
What you need to know about personal loans for debt consolidation
Many people take out personal loans for meeting a wide range of needs. When you take out a personal loan for debt consolidation, you will need to consider the exit fees and early repayment costs of your existing loans. Doing so will help you determine whether the cost of consolidating your loans is more than the money you’ll end up saving.
There are a number of different types of personal loans, such as car loans for purchasing vehicles, unsecured loans for taking a holiday, and so on. Debt consolidation loans are designed to help you bring together separate loan and credit accounts. There are a few types of different loans that can be used to consolidate debt:
- Fixed personal loans that have fixed interest rates and repayments
- Variable rate personal loans that usually offer lower interest rates than their fixed counterparts. There is, of course, the catch that these rates could rise in the future
- Unsecured personal loans that give you access to funds even if you don’t have any assets to guarantee the debt
- Debt agreements that are a type of bankruptcy. These are usually taken out by people with larger debts or for those with bad credit.
Are home equity loans better than personal loans?
Both home equity loans and personal loans offer specific benefits. In particular, the former is useful when you have aggregated equity in your house, while the latter is useful especially if you don’t have any assets to guarantee the loan.
Home equity loans can also offer considerably lower interest rates than personal loans. This means that your monthly instalment for any additional amount you withdraw on the home loan will be much lower than if you took out a personal loan. Keep in mind, however, that this interest is spread over a much longer term – 25 or 30 years compared to a maximum of seven years for a personal loan. Because of this, it's likely you'll pay more with a home equity loan.
For both personal loans and drawing on home equity, you may need to pay associated fees depending on the requirements of the product. If you stay with your current mortgage lender you may be able to avoid refinancing fees depending on the flexibility of your loan, but again, it depends on the lender and on the loan in question. Refinancing with a separate lender almost always carries additional fees and charges, so this will need to be taken into account.
Consider that you’re five years into your 25-year home loan and you need a loan of $20,000. The interest rate on a secured personal loan is 8.9%, while your home loan offers 6.39%. To accommodate the additional debt, your monthly instalments on your home loan will increase by $148, while you will need to pay $321 each month for seven years if you take out a personal loan. At this stage, the redraw on the home loan seems worthwhile.
But over the life of your home loan you will end up paying a total interest of $15,477 for the $20,000 you borrowed. In comparison, the total interest and fees of your personal loan will amount to approximately $7,000-$7,500.
In this scenario, even at a higher interest rate, the personal loan will be much cheaper over the maximum term of seven years as opposed to a home loan that stretches for the next 20-30 years at a lower interest rate. To remedy this, you could consider taking advantage of the redraw on your home loan and repaying it at a faster rate than your existing monthly mortgage instalments.
When should you opt for home loan redraws and personal loans?
The key to consolidating your loans lies in maintaining the same repayment levels at lower interest rates without extending the life of your loans. So if you need the funds for a short-term duration, avoid paying the additional fees associated with personal loans. Rather, you can consider a home loan redraw. But if you feel that you will only be able to repay the loan within the next five to seven years, consider taking a personal loan instead. Some personal loans give you the option of early repayment without penalty, so there is this to take into account as well.
It is worth noting that the longer you carry your debt, the more you pay in interest. It’s always best to avoid increasing your debts to such unmanageable proportions. Be mindful that just because you have equity you shouldn’t keep borrowing against it. Focus instead on living within your means and avoid spending more than you earn. This approach will make your credit report look good and keep your debt manageable. It will also make your life easier and relatively stress-free.