You've spent the past few years being dumb with money. You realize that now. Your credit cards are maxed out, you're living paycheck-to-paycheck, and you cannot see a way out. You plan to sell some stuff and to take a part-time job, but you're looking for other ways to ease the burden. If you're a homeowner, one option to consider is tapping your home equity to consolidate your consumer debts.
Just what is home equity anyhow? Home equity is the difference between what your property is worth and what you owe on it. If your home is currently worth $200,000, for example, and your mortgage balance is $150,000, then you have $50,000 of equity.
Under normal circumstances, this equity remains untapped, increasing slowly with time. There are, however, a couple of ways to use home equity for other purposes:
- A home equity loan (HEL) is essentially a second mortgage. The homeowner borrows a lump sum from the bank using the equity in their property as collateral. This sort of loan generally has a fixed interest rate and a term of ten to fifteen years.
- A home equity line of credit (HELOC) is slightly different. HELOCs are revolving credit accounts, much like department store credit cards. The homeowner can borrow money repeatedly, as long as the HELOC's credit limit is not exceeded. HELOCs generally have variable interest rates.
Traditionally, home equity loans (and lines of credit) have been used to fund property improvements such as remodels and additions. Over the past decade, however, it has become fashionable to use this money for consumer spending. Or for debt consolidation.
Robbing Peter to Pay Paul
Using home equity to pay off debt is an appealing option. You can obtain a loan with an interest rate in the neighborhood of 8%. Your credit cards probably charge twice that. If you're paying on multiple credit cards, it's likely that your combined payments are higher than the single payment on a home equity loan would be. And in most cases, interest paid on a home equity loan is tax deductible, the same as mortgage interest.
However, home equity loans are not a panacea. They don't eliminate debt — they just shift it from high-interest to low-interest accounts. And if you fail to change the habits that led you into debt in the first place, you will likely accumulate even more debt in the long run. Most importantly, a home equity loan puts your house at risk — credit cards do not.
Despite these drawbacks, debt consolidation can be an excellent way to arrest the downward spiral and to take control of your finances.
I took out a home equity loan to pay off my credit cards.
In 1998, I had more than $16,000 in credit card debt. I applied for — and was granted — a home equity loan. I used this money to pay off my outstanding debt. I cut up my credit cards. When I was certain that my balances were paid in full, I cancelled the accounts.
I paid faithfully on this loan for five years (it had a ten year term). But when we bought our new home in 2004, the intricacies of the transaction (read: my lack of savings) forced me to fold my previous home loan into a new HELOC: $21,000 at 6%.
For a while, I made the interest-only minimum payments. Time passed. The minimum payments began to rise. I was puzzled until I noticed that my interest rate was also increasing. This was alarming, and it prompted me to attack this debt in earnest. In fact, just this month I mailed the final check to pay off my home equity line of credit.
Tapping home equity allowed me to get rid of high-interest credit cards and begin down the path of smart personal finance. It wasn't an immediate turn-around — I took out a car loan and a couple of personal loans before realizing the error of my ways — but the change did happen, and this second mortgage was an important piece of the puzzle.
After carrying a home equity loan for nearly a decade, I learned some things along the way:
- The interest rate on your home equity loan should be lower than the interest on your credit cards. This is likely the case. However, if you have cards with low rates, you're better off exercising the discipline to pay them down instead of taking out the loan.
- I prefer a home equity loan to a home equity line of credit. The latter is more flexible — you can draw on it repeatedly if you need — but the interest rate is higher. Your goal is to reduce your debt burden, not increase it.
- Arrange to have the bank pay off the balances on your cards when the loan is funded. If they're not able to do this, make paying off your credit cards the first thing you do when you receive the money.
- Destroy your cards. Burn them. Cut them up. Shred them. I believe it's important to avoid credit cards completely until your home equity loan has been repaid.
- As you receive statements from your credit card companies indicating $0 balances, call to cancel the cards. Many experts warn against closing credit card accounts because it dings your credit score. My credit score dropped some because of it, but I don't care. I'd rather have a good credit score and not be tempted to new debt than have a great credit score and be piling up the problems.
- Live without credit. Yes, you may need to buy a car on credit, but otherwise refuse to take on new debt. Taking on new debt simply defeats the purpose, and puts you in worse shape than before.
If you follow these guidelines, the equity in your home can be a valuable tool to help you escape from consumer debt.
There are some real dangers associated with using home equity (which is debt secured by your property) to pay down credit card debt (which is unsecured debt). If something goes wrong, you could lose your home.
If you do choose to go this route, please make a commitment to avoid credit cards (and other consumer debt) completely until you've finished repaying the loan. If you're able to exercise a little self-discipline, a home equity loan can be an excellent way to put the brakes on bad habits, and a chance to make a fresh start.
Author: J.D. Roth
In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.