Earlier today I wrote about using a home equity loan to pay off credit cards. I suggested that this may be a good option for somebody who has arrested her spending and is ready to focus on debt elimination. It's a move that carries a big downside, though, and is certainly not a good choice for everyone.
When I took out my home equity loan in 1998, I wasn't aware of any other options. I was swimming in debt and dying to get free. Somebody told me about using the value of our house to take out a loan, and it sounded liked a good idea. It never occurred to me to explore other possibilities. I wasn't financially savvy.
Now, however, I know better. If I were faced with the same situation today, I'd try two other approaches before using home equity to pay off debt.
Asking for a better deal
Many GRS readers have told stories describing how they've been able to get their credit card interest reduced simply by asking. In our discussion this morning, The Saving Freak even offered a template for doing this:
Most credit card companies will reduce the rate to something close to your home equity if you just ask politely. The line we coach people to use is, “I am trying to get out of debt and I need your help. Will you please reduce my interest to 0% for 12 months so I can get out of the hole I have dug for myself?” Usually they will come back with some offer at like 3, 6, or 8 percent. This is still a better option than home equity since they cannot come after your house if something happens and you cannot pay it.
A single phone call may get your credit card interest reduced to a rate similar to what you would pay on a home equity loan!
Implementing a debt snowball
A second strategy is to knock out some of your low-balance debt quickly. I'm a firm believer in the psychological benefits of the debt snowball as popularized by Dave Ramsey. I had never heard of this concept a decade ago, or I might have considered it. When I did learn about it in 2004, it became a key piece of my debt-elimination plan. Here's how this system works:
- Order your debts from lowest balance to highest balance.
- Designate a certain amount of money to pay toward debts each month.
- Pay the minimum payment on all debts except the one with the lowest balance.
- Throw every other penny at the debt with the lowest balance.
- When that debt is gone, do not alter the monthly amount used to pay debts, but throw all you can at the debt with the next-lowest balance.
Though this method is not mathematically optimal — in theory, you'll end up paying a little more in finance charges than if you attacked high-interest debt first — it has huge psychological benefits. It gives you quick victories, and helps you understand that you can take control of your finances and change the way you deal with money.
Addressing the real problem
Really, though, these methods all fail to address the real problem. Overcoming debt is not a matter of shuffling balances or finding the optimal payment schedule. Debt elimination starts with you. If you want to escape the burden of high credit card balances, you must make a conscious decision that you're ready to spend less than you earn. You must abandon the use of credit altogether, at least until your existing debt has been repaid.