Can your home equity solve your debt problems?

By Michele Lerner
Mortgage Credit Problems Columnist

If you are among the homeowners who have paid off their mortgage in full or who have paid down their loan balance, a home-equity loan or cash-out refinance may offer a way to address your credit problems.

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Before you get too excited, though, you need to realize that lenders today will carefully review the credit qualifications of all borrowers for home-equity loans and home refinances. If your credit score is below 640, you may have trouble qualifying for a refinance or a home equity loan no matter how much equity you have.

In addition to your credit score, lenders will need to review you debt-to-income ratio to determine whether you can afford your mortgage payment. If your overall debt payments, including your new loan payment, exceed 41 percent of your monthly gross income, you may have a hard time qualifying for a loan.

Home-equity loan vs. cash-out refinance

Lenders tend to be strict in their credit qualifications for all borrowers, but some may be even more stringent in their requirements for borrowers who apply for a home-equity loan. The reason for this is simple: A home equity loan is a second mortgage, so if you default on your loans and your home goes to foreclosure, your first mortgage will have priority in terms of which one is repaid from the sale of your home. If you have a lot of equity, this may be less of a concern, since presumably the sale of your home could easily pay off both loans if, for example, you have 50 percent equity in the property.

A cash-out refinance may be an easier option, since you would pay off your current mortgage with the refinance and have just one mortgage moving forward.

To compare the two loan options, be sure to look at the interest rates on both, as well as the other costs of the loan. A home-equity loan typically has fewer fees than a refinance, so if you can qualify for one, that may be a better way to keep your overall mortgage balance as low as possible.

But no matter what option you choose, be sure to manage your credit carefully after securing your loan to help prevent debt from becoming a problem again.

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