How to Use a Home Equity Loan to Pay Off Debt

If you’re a homeowner who has several high-interest loans and lines of credit, you may have considered using a home equity loan to pay off debt. It’s a smart and convenient way to combine multiple debts—often with a lower interest rate than other types of lending solutions. 

But once you’ve decided this is the right option for you, how exactly do you get the ball rolling?

Here, we’ll walk you through using a home equity loan to pay off debt so you can understand what to expect at each step. Whether you’re dealing with credit card balances, personal loans or other forms of debt, find out how to put your home equity to work.

How to Use a Home Equity Loan to Pay Off Debt

A home equity loan acts as a second mortgage, or lien, that you take out in addition to your primary mortgage. You’ll use the funds from your new home equity loan to pay off your existing lenders. Then you’ll begin making payments on your home equity loan.

Let's break it down, from your first move to your last.

1. Evaluate your current debts and credit score

Start by looking at your financial situation and current debts. Create a list or spreadsheet with each debt, including the lender name, current balance, interest rate, minimum monthly payment and due date. Include credit cards, personal loans, medical bills and any other outstanding debts. Also, see if any of your current debts have prepayment penalties because that could affect your decision to pay them off early.

Next, calculate your total debt and your average interest rate. This will help you decide how much you’ll need to borrow and what interest rate you should aim for with a new home equity loan. 

You also need to review your credit history because that information helps lenders determine if you’re eligible and what your borrowing limits may be. You may have to work on raising your credit score before applying for a home equity loan. 

2. Explore home equity loan options

First, you need to know how much equity you have in your home. Your home’s equity is the difference between your home’s current market value and your remaining mortgage balance. For example, if your house is worth $350,000 and you owe $275,000 on your mortgage, your equity is $75,000. Most lenders allow you to borrow up to about 80% of your equity. That’s $60,000 in this example ($75,000 x 0.80) that you could tap into.

Calculate how much you could potentially borrow with a home equity loan based on your own home’s value and your remaining mortgage. Then, compare home equity loans from multiple lenders, including banks, credit unions and online lenders. Look at:

• variable interest rates vs. fixed interest rates
• loan terms (typically between 5 and 30 years)
• fees (application fees, closing costs, annual fees)
• repayment options
• customer service ratings

3. Apply for a home equity loan

After you’ve done your research and selected a lender, it’s time to apply for a home equity loan so you can lock in your desired rate. 

Applying for a home equity loan is a simple process. You’ll need to gather a variety of financial documents, including:

• proof of income (pay stubs, W-2 forms, tax returns)
• bank statements
• mortgage statements
• property tax bills
• homeowners insurance information
• details of your current debts

The lender likely will require a home appraisal to confirm your property’s value. The lender also will check your credit score and calculate your debt-to-income ratio (DTI). Aim for a DTI that’s below 43%, which is often the highest ratio that lenders will accept.

You can expect to wait 2-6 weeks to close on your home equity loan, depending on the lender and how complex your financial situation is.

4. Close on your home equity loan

After your lender underwrites the home equity loan (which happens before closing), you’ll be provided with a closing disclosure that outlines all the terms of your loan. Review this document thoroughly, and pay special attention to:

• loan amount
• interest rate and annual percentage rate (APR)
• monthly payment amount
• loan term
• closing costs and fees
• any prepayment penalties

At closing—whether in person or virtual—you’ll sign several documents, including the promissory note and the deed of trust or mortgage. If this is for your primary residence, you’ll also sign a right of rescission notice, which gives you 3 business days to cancel the loan if you change your mind.

Make sure you understand all terms before signing and ask questions if anything is unclear.

5. Pay off your current lenders

After closing, you’ll receive your new home equity loan funds, typically as a lump sum. Use those funds to begin paying off your separate debts.

Contact each lender for your final payoff amount, which may be slightly different from your last statement. After you make a lump sum final payment to each lender, keep detailed records of all payoffs, including confirmation numbers. Check your credit report 1-2 months later to confirm the paid-off accounts are correctly reported.

6. Make on-time payments on your home equity loan

With your debts paid off, start making regular, on-time payments on your new home equity loan. Your home is collateral for this loan, so you must make consistent payments to reduce the risk of losing your home through foreclosure. Set up automatic payments, if possible, to avoid any late or missed payments. 

7. Make a financial plan

A home equity loan can be a powerful tool for debt consolidation, but it’s most effective when combined with smart financial habits.

After you’ve consolidated your debts into a home equity loan, take steps to avoid overextending yourself and falling back into debt. You could create a detailed monthly budget to track all income and expenses, build an emergency fund to cover unexpected costs and/or meet with a financial counselor to create a long-term financial plan.

How Navy Federal Can Help You Pay Off Debt

Navy Federal is committed to helping you take control of your debt. We provide a wealth of financial education resources through MakingCents, covering topics such as debt management and home equity. Plus, our online calculators can help you estimate loan amounts and payments.

Our experienced loan officers are ready to guide you through the home equity loan application process. And, for personalized financial advice, speak with one of our financial counselors. They can help you create a debt management plan and a budget that helps you say goodbye to debt—for good.