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Using home equity loan to pay off debts

Dear Dr. Don,
My wife and I (both of us are 30) are thinking of taking out a home equity loan (7.25 percent for 15 years) for several reasons. One is to pay $8,000 to hook up to city water (by law). The second reason is to pay off a higher variable rate personal loan (approximately 13 percent) with five more years with a $15,000 balance. This was mostly for medical bills and some financial trouble we got into earlier.

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Next, I would like to pay off about $5,000 in credit card debt and pay off a car loan -- about $9,200 for four years at 5.25 percent. A second car loan is 1.9 percent for four more years and we would not consolidate this loan. Finally, the rest would be used to do several projects around the house.

We have a mortgage balance of $89,000 and the house was appraised for $271,000 in the past year. After the credit cards are paid off, we would like to close four of the seven accounts and keep the other three open. We figured out we can save almost $300 a month with this loan. Is this a good idea? We are tight on our budget and any advice would be helpful. We would like to be as debt free as possible and would like to breathe easier financially.

Thank you,
-- Charles Consolidate

Dear Charles,
Restructuring your debts by using a home equity loan to replace the other debts has its pros and cons. Consolidating the debts at a lower interest rate over a longer time frame can make these debts easier to manage in your monthly bills, but you might end up spending more money on interest because of the longer repayment period. You've also securitized some unsecured debts, putting your house at risk if you don't keep up on the payments. Paying off your credit cards frees up those credit lines, and if you use that as an excuse to run up those balances all over again the restructuring didn't solve the problem of spending more than you make.

Closing some of your credit card accounts, after the restructuring, reduces your available credit lines and might be effective in keeping you from backsliding into misusing credit cards. The downside of closing these accounts is that it is likely to have a negative impact on your credit score. The length of credit history, mix of available credit and ratio of outstanding-debt-to-available-credit all influence your credit score. Closing the accounts won't help your credit score in the short-term.

If you can use the mortgage interest deduction on your taxes, the effective rate on your home equity loan is even lower than the quoted 7.25 percent rate. A CCH calculator will help you calculate the effective rate. Lowering the effective interest rate on your outstanding debt reduces your interest expense, assuming you pay it off over the same time period as the other loan.

Whether it makes sense to pay off your 5.25 percent auto loan by using part of the proceeds of the home equity debt depends on the effective interest rate on your mortgage loan. But taking 15 years to pay off a depreciating asset like a car makes no real financial sense. That car will just be a memory by the time the loan is paid off.

You've been a little loose on how much money you plan to borrow with this home equity loan and what remodeling plans you have for your home. It's clear that you have to hook up to city water and pay $8,000 for the privilege. Restructuring the other debts can have some advantages, but you're also planning to take on new debt for the projects around the house.

The bottom line is that you might be reducing your monthly nut by $300 but not saving any money by taking this step. You have to balance the need for freeing up these funds against extending your existing debts to a 15-year payoff schedule, even at a lower interest rate, and the need for these home improvements. Taking out the home equity loan can be the right move. Just go into it understanding the trade-offs you've made to restructure your outstanding debts.

Bankrate.com's corrections policy -- Posted: Jan. 26, 2006
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