If you have five or even six figures in outstanding high-interest debt, you might be able to clear it all using the value of your home. Learn how you can use a home equity loan to consolidate all your debt – including pitfalls to watch out for.
Einstein once supposedly referred to compounding as the ‘eighth wonder of the world’. And indeed, compounding can be almost magical (read this article for an example of how investing a mere $2,000 each year could eventually lead to over $451,000).
But compounding is a double-edged sword. It can work for investing, but it can work for debt as well. Credit cards are a simple example. A seemingly ‘moderate’ balance – if left to compound (i.e. you only make the minimum monthly payments) – can quickly swell to eye-popping amounts, with the interest portion of the amount owed dwarfing the original principal.
But hey, we’re not here to judge. We’re here to help. If you have a debt problem, here’s a potential solution: home equity loans.
(Note: They’re also known as a cash-out refinancing, second mortgage, or mortgage equity withdrawal loan.)
We’ll give you the rundown on what it takes to qualify for one, the step-by-step process to get one, how it can help with your debt repayment – and importantly – the pitfalls you must watch out for.
What is a home equity loan (and do I qualify for one)?
First, let’s define the term ‘home equity’. If you remember your accounting classes, equity equals assets minus liabilities. Thus, home equity is the market value of your home (asset value) minus your outstanding loan amount (liabilities).
Your home equity is the ‘real’ value, but it only exists on paper – you can’t really do anything with it (i.e. convert it to cash) unless you sell your home, or take out a home equity loan. A home equity loan is thus a way for you to cash out your home equity.
Essentially, how it works is: you go to a bank, apply for the loan, and if it’s approved, you’ll get a large sum of cash (possibly hundreds of thousands) wired to your bank account. You won’t have to sell your house – nor will the bank tell you what to do with the money – but keep in mind that the bank has a right to foreclose on your property if you default.
Not every property owner will qualify for one. In fact, since HDBs outnumber private properties five-to-one, it is safe to say that most property owners will not qualify for a home equity loan. Here are the ‘rules’ for home equity loans:
- Can only be taken out against private properties, not HDBs
- Property has been occupied for at least 5 years
- Maximum tenure of 35 years
- Loan-to-Value (LTV) limits of 75% still apply
- Total debt servicing ratio (TDSR) requirements do not apply if LTV remains below 50%
- You cannot use your CPF funds to service the repayments
How much can I ‘cash out’ from my home equity?
The amount of money you will be able to borrow from a home equity loan can be calculated using the formula below:
[Up to 75% of current home value] – [Outstanding loan amount] – [CPF amount used for your home]
This means that if the sum of your outstanding loan amount and CPF balance used exceed 75% of your current home value, you will not be able to get a home equity loan. Further, although the Monetary Authority of Singapore (MAS) determines the maximum amount you can borrow, banks will apply their own discretion as well. Just because you can borrow up to 75% of the property’s market value doesn’t mean the bank will approve it.
Still, it's obvious that there is potentially a lot of money to be unlocked from a home’s equity. According to real estate research firm CBRE, the average private property price in Singapore was about $875,000 in 2018. A 75% LTV thus gives a theoretical maximum home equity loan amount of $656,000.
Even if we assume $200,000 in remaining loan outstanding and another $200,000 in CPF monies used, that’s still over $250,000 you could possibly cash out from your home.
And as we said earlier, the bank is not going to tell you what to do with that money (it just wants to make sure you can pay it back). But a great way to put that money to good use if you are facing debt troubles is to…
Use it to consolidate your debt
The concept behind debt consolidation can be summed up in a single line: using the cash proceeds from a single low-interest loan to pay off all your other debts. Now, instead of having to deal with multiple (probably high-interest) debt, you can focus on paying off just one (preferably low-interest) loan.
Not only do you save a lot of money on interest costs (remember the power of compounding), it is also easier from a financial management perspective. You only have one loan to pay, which is easy to keep track of.
The nature of a home equity loan makes it perfect to use for debt consolidation. The amount is large enough to cover most other personal debts, and the interest rate is also low. As home equity loans are secured against your property – just like a regular mortgage – the interest rates are about the same as mortgages as well. And right now, they are lower than they have ever been, with floating rate loans reportedly coming in at just 1.4 - 1.8% per annum as of June.
So, if you’re struggling with multiple high-interest personal debts – and you qualify for a home equity loan – this method of debt consolidation may be the answer. Here’s how you can go ahead and apply for a home equity loan (and what you should be aware of).
A step-by-step process for applying for a home equity loan (and what to be aware of)
There’s actually nothing complicated about applying for a home equity loan. All you have to do is review the qualification criteria we listed above so you don’t waste your own and the bank’s time. Then, begin ‘shopping around’ the banks for the best interest rate. Think of it like finding a home loan, only easier and faster with less hassle.
However, there is one thing you should be aware of: the high upfront fee. Because a home equity loan is based on the current market value of your home, the bank will require an official valuation first. That, plus legal fees, could cost you anywhere from $2,000 to $3,000 in upfront fees. Make sure you have the cash on hand before applying.
Another thing you should know is that a home equity loan is not ‘instant cash’. Because of the paperwork involved and the size of the loan, it can usually take up to a few months for everything to be processed. But if you can wait a few months and then use it to consolidate your other debts, home equity loans are a great solution.
To summarise the characteristics of home equity loans, let’s look at how they stack up against the much more common personal loan.
|Home equity loan||Personal loan|
|- Interest rates similar to mortgages|
- Secured against property
- Much higher loan amount of up 75% of property value
- Longer tenure of up to 35 years
|- Higher interest rates|
- Generally unsecured
- Much lower loan amount, typically up to 4 times monthly income
- Loan tenure usually a maximum of 7 years
Still, while home equity loans have a lot of benefits, there are a few pitfalls you must watch out for.
The dangerous pitfalls of home equity loans (watch out for these)
We’ve already addressed the relatively high upfront administrative fees and the long waiting period for home equity loans. But that is just part of the process – it’s not really a ‘pitfall’. Indeed, the main pitfall you must watch out for… is yourself.
That’s right. Because banks won’t tell you what you must do with the loan proceeds, the temptation to spend the (large sum of) money unwisely can be very high. Yes, you might tell yourself in the beginning that you are going to use the money to consolidate your debt. But once you see the funds in your bank account, the story you tell yourself can quickly change.
This is a dangerous trap. Don’t forget that the loan is secured against your property and that you are not allowed to use your CPF to service the loan. Using the proceeds unwisely can thus lead to you getting yourself even deeper into debt or even potentially losing your house.
To avoid this, we suggest you limit the loan amount to precisely the amount you would need to cover all your other outstanding debts. Remember, if you are using a home equity loan to consolidate your debt, the last thing you want is to exacerbate your problems.
Read these next:
How Much Do You Need To Buy Your First Home In Singapore?
Home Insurance Promotions And Discounts To Protect Your Home
What is a Debt Consolidation Plan and How Does it Work in Singapore?
4 Ways to Pay Off Credit Card Debt in Singapore
HDB Loan Vs Bank Loan: Which One Should You Go For?