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HELOC vs. refinance for debt restructuring

Dr. Don TaylorDear Dr. Don,
My husband and I want to obtain some money to pay off credit debt and also upgrade our home that we purchased six months ago. My question is: Which would affect our credit score more, a HELOC or to refinance our first and second mortgage loans into one loan and use some of the equity to do this? Someone told me that a HELOC looks like a big credit card debt.
-- Lisa Loanable

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Dear Lisa,
You're not paying off credit card debt when you take out a loan to fund the payoff; you're just restructuring the debt. Debt restructuring can make sense if it reduces the interest rate on the debt or spreads it over a longer time period. Since credit card debt doesn't have a defined maturity, you're looking to reduce your effective interest rate. Besides having a lower interest rate, the interest expense on a home equity line of credit may generate a tax deduction, moving the effective rate even lower.

That said, I'm concerned that you've only owned this house six months, you already have a first and second mortgage, and you're looking to tap your equity yet again to restructure your credit card debt and renovate the home. A HELOC would actually be a third mortgage, with the first and second mortgage having priority in a default situation. Sitting third chair instead of second will make the HELOC a riskier loan with a higher interest rate.

A cash-out refinancing of the existing first and second mortgage can get you past the third mortgage issue, but the closing costs on a first mortgage are going to be substantially higher than a HELOC. Let's just say that it's an additional $3,000 to do a cash-out refinancing. That's money that could be going toward paying down your credit card debt or funding the upgrades on your home. You need pretty compelling reasons to refinance when you're only six months into a mortgage loan.

Trying to decide which method of financing will best protect your credit score is a little backward. You need the good credit score to get the best financing now. Worrying about the loan's impact on your credit score going forward means you're anticipating the next loan. After six months and a potential third visit to the mortgage markets, you should plan on taking a breather.

Getting back to your actual question, a HELOC doesn't look like a big credit card debt because it's backed by a security interest in your home. As long as you haven't forayed into borrowing more than your home is worth with a 125-percent loan-to-value HELOC, the equity backing of the secured debt isn't as risky as a like amount of unsecured debt.

The HELOC and credit cards are alike in that they are both lines of credit and the size of the lines and the amount of available balances will impact your credit score. Using a HELOC to restructure your credit card debt will free up available balances on your credit cards, but having a third mortgage isn't likely to help your credit score.


-- Posted: Nov. 22, 2004





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