If you're drowning in debt, using your home equity for debt consolidation can be the life preserver you desperately need. Understanding how to use your home equity for debt consolidation can help you get a handle on your current finances and manage it better in the future.

What is home equity?

Home equity is the part of the home you own. You build equity as the principle on your mortgage is paid off, and as your home's value appreciates. To estimate how much home equity you have, subtract the remaining balance on your mortgage from the total value of your home. For example, if you have a home valued at $250,000 and owe $150,000 on the mortgage, your home equity equals $100,000. When you sell your house, you receive that difference. You can also borrow against your home equity while still living in the house and use it for debt consolidation.

How can home equity help to consolidate debt?

If you have a high load of credit card debt, car debt, etc., your home equity can bring you some relief. Unsecured debts like these typically carry high interest rates. That means you can spend a considerable amount of money each month on interest payments and still not reduce your debt load. By consolidating your debt using your home equity, you'll be paying less interest -and paying the debt off faster.

What are the options for using home equity?

If you decide to use your home equity to consolidate your debts, you have a couple of different options, although one is usually better.

• Home equity line of credit (HELOC) -When you take out a home equity line of credit, a lender advances you an amount of money up to your credit limit. You get that money as needed and access it using a credit card, checkbook, or debit card. The interest rate is usually adjustable, and you pay interest only on the amount you withdraw. However, HELOCs are usually more appropriate for uses that require payments over a time period, such as college tuition or home improvements.
• Home equity loan (HEL) -A home equity loan is usually the better option for debt consolidation. It involves getting a second mortgage using your home equity. You borrow a lump sum at a fixed interest rate and make monthly payments on the HEL. HELs usually work better in a situation where you need the money all at once, such as with debt consolidation.

How is home equity used to consolidate debt?

Lenders use a formula to determine how much of your home equity is available to use as a home equity loan. For example, on a home that has been appraised at $150,000 where the owner owes $50,000 on the mortgage, the equation would work as follows:

This means that the borrower in this situation could get a home equity loan of up to $70,000.

If you determine this method of debt consolidation is right for you, you would use the home equity loan to pay off your creditors and then repay the second mortgage to your lender. You should save a significant amount in interest payments, and your debts will be wrapped up into one convenient payment. Also, the interest on your home equity loan should be tax deductible (be sure to check with your tax advisor).

One key point to remember is that your debt is now in your second mortgage, so it's secured with your home. If you default on the loan, you can lose your collateral (your home). Therefore, it's very important to look at all variables when considering using your home equity for debt consolidation, and to be sure you can make your monthly payment.