Home Equity Loans versus Debt Settlement

The housing bubble saw tremendous increases in home equity values. Skyrocketing home prices led to many people taking loans out on their equity to fund consumption. Home equity is the difference between the price and the mortgage balance. Equity can be positive or negative; negative equity means the mortgage balance is greater than the price of the home. Home equity is a source of cash that can be accessed through bank lending. Home equity loans, also known as second mortgages, are loans that collateralize the equity in exchange for a lump sum.

An alternative to home equity loans besides debt settlement are home equity lines of credit (HELOCs). A HELOC works exactly like a credit card. The bank gives the homeowner a revolving balance that the homeowner can draw against and repay. HELOCs are a little more complicated than a home equity loan, but the basic principle is the same. Home equity loans are not revolving credit like HELOCs are.

Unfortunately, the mass consumption prevalent during the boom has evaporated in the bust. Enormous debt loads have been left behind, resulting in a frenzied attempt to pay down debts among most homeowners. Some indebted homeowners, laden with multiple sources of debt, are turning to home equity loans or HELOCs to repay their debts. This is the idea of debt consolidation: Taking on an additional loan to pay off all other outstanding loans and then paying off the new loan over time. Debt consolidation has been the only hope for many debtors locked in the vicious spiral of debt, while rising interest rates on revolving and fixed debt push them closer to the brink of default.

Debt consolidation can work only in certain situations. The debtor in question must have a low enough debt-to-income ratio to handle the debt consolidation loan. The debt-to-income ratio is the percentage of monthly income that goes towards paying down debts. If this number is too high, the debtor is already out of luck. No lender will lend to a borrower, especially in a time of recession and strict lending standards, if his debt load exceeds a certain portion of his income.

Additionally, the debtor must not already be in default. If he is, he will have to go the alternate route of credit counseling or even bankruptcy. Debt consolidation may seem like pouring more gasoline onto the fire, but it is often the only option available to preserve a debtor's credit rating.

The primary advantage of taking out a home equity loan or HELOC for purposes of debt consolidation is saving money through interest rate differences. Lenders, such as credit card companies, often increase interest rates if they feel a borrower is racking up too much debt relative to his total credit limit. A HELOC or home equity loan can have lower rates than credit cards and other forms of debt, so the debtor saves money. Depending on the debtor's credit rating, this may not be the case. The debtor resigns himself and bites the bullet if this is so.