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Credit card balances force debt restructuring

Dear Dr. Don,
I'm presently working on refinancing my home so that I can take some money out to pay off my credit cards that have interest rates as high as 30 percent. One card has about $12,000 with interest of 30 percent and the other has an $8,000 balance with an interest rate of 20 percent.

The current interest rate on my home is 6 percent and the refinance rate will be 8 percent, since my credit rating is not that good due to the high balances on my cards. This will increase my monthly mortgage payment by 25 percent. The loan balance on my house is about $300,000. The house should appraise for about $495,000 and I'm two years into a 30-year fixed-rate mortgage.

So, do you think it is a good way of paying off my credit cards and improving my credit, or should I gradually pay off my cards starting with the high interest rate ones and pay off at least 50 percent within the next six months? Please advise.

-- Thanks,
John Joust

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Dear John,
I'd much rather see you keep that 6 percent mortgage. If closing costs on the refinancing are $3,000, you've just spent 15 percent of your outstanding credit card debt just for the privilege of making it secured mortgage debt that you can repay over the next 15 to 30 years.

With close to $200,000 equity in your home, a home equity loan or a home equity line of credit (HELOC) is a much smarter way to restructure your credit card debt. The closing costs will be much lower than the costs associated with refinancing the first mortgage and you will be paying the higher interest rate on just the home equity debt. There are pros and cons to both types of home equity debt. I'd lean toward the HELOC, even though it is variable rate debt, if you don't have much of a cash reserve for emergencies, and toward the home equity loan if you're fairly comfortable with your cash reserves.

Key in all this is to not use the sudden influx of credit as an excuse to run up your credit card balances all over again. View the home equity line/loan as a restructuring of your credit card debt, not a license to spend more. If you take this approach, you'll have changed your unsecured credit to secured credit, backed by the equity in your home. You still need to get spending under control and work on paying off the equity line as quickly as is practical. You don't want to finance this year's holiday spending over the next 20 years.

Credit card companies use risk-based modeling to determine what interest rate you pay on your credit card. You didn't get a 30 percent rate on your credit card by paying your bills on time. Paying down these card balances will do a lot toward improving your credit. As you move toward accomplishing this goal, talk to the card providers about lowering the interest rate on your credit cards. It'll be a good barometer for whether or not you want to stay with these firms when your credit does improve.

Bankrate.com's corrections policy -- Posted: Dec. 30, 2005
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