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Cons of using home equity to consolidate debt

Keep your cotton-pickin' paws off your nest egg.

Using home equity to pay off bills and make major purchases always looks good on paper; that's why so many folks are doing it. How can you argue with lower monthly payments, tax-deductible interest and no more credit card debt? It's easy when you're the Dollar Diva.

Lower monthly payments
If you're a typical American consumer, you have too much high-interest debt, and it's costing a bundle to service it. When a lender offers a chance to lower those monthly payments with a low-interest, home equity loan or a cash-out refinancing, it can feel like manna from heaven. But don't kid yourself; no one's passing out free lunches. When you tap home equity to pay off bills, you kiss off those high monthly credit card payments, but you don't kiss off the debt.

The lower monthly payment makes the debt look harmless. Look closer and behold the same old wolf; he's just decked out in grandma's bonnet. Even though the interest rate is less and the monthly payments are low, you usually end up paying more over the long run because the payments are stretched out over a longer period.

When debtors use home equity to pay off their bills, they usually swear to God they'll never carry a credit card balance again; but they forget to change their spending habits, and they forget to save for emergencies and big-ticket items. When the car needs a new transmission, or they "need" a vacation, the plastic get resurrected and the debt cycle resumes.


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Tax-deductible interest
Tax-deductible interest is the war cry lenders use to prod unwary homeowners into using their precious home equity to fund major purchases and pay off debt. It sounds good until you start running the numbers. Let's pretend you have $40,000 in 18 percent credit card debt; your current monthly payment is $1,000. Continue the $1,000 payments, and the debt is history in 62 months. Total payments will be $62,000 ($1,000 x 62) and total interest will be $22,000 ($62,000 minus $40,000).

Use a 9 percent home equity loan to stretch the payments out over 180 months and payments go down to $406. Total payments will be $73,100 ($406 x 180) and total interest, $33,100 ($73,100 minus $40,000); you'll pay $11,100 more interest with the home equity loan. If you're lucky, the tax deduction will compensate for the extra $11,100, but don't count on it. The lenders are the only ones who can bank on making big bucks on home equity loans; that's why they spend big bucks marketing them.

No more credit card debt
Tapping home equity makes it easy to get rid of credit card debt, but that state of bliss is usually fleeting. Why do folks rack up so much credit card debt in the first place? Could they be living beyond their means? Most folks who use debt to get rid of debt forget to change their negative spending habits and end up deeper and deeper in the hole.

Home equity loans can be expensive
Home equity is something to cherish and preserve, not deplete. Here's what no one tells you when you sign off on that home equity loan:

  • Home equity is a time-proven way to accumulate wealth and provide a sense of security; when you tap it to pay off bills, you become poorer.
  • Use home equity as a money tree and you could end up paying private mortgage insurance (PMI) forever.
  • Credit card companies can't foreclose on your home if you run into financial difficulties. But home equity loans and cash-out refinancings are debts that are secured by your home. If you can't make the payments, you risk living in a corrugated box.
  • How about those loan origination fees and prepayment penalties?

Conclusion
For most folks, the road to getting out of debt and achieving financial independence is paved with discipline and belt tightening, not more debt. Debt paves the road to bankruptcy court. Here are some tips to help you get on the high road -- to financial freedom:

  • Spend less than you earn, and save the difference.
  • Resolve to be debt free, and lay out a strategy to make it happen.
  • Invest in yourself -- you are a money making machine; the more money you make now, the quicker you'll achieve financial independence.
  • Keep your cotton pickin' paws off the equity in your home.

Postscript
As a general rule, tapping home equity is a no-no; but where is it written you can never break a rule? If you give birth to triplets and need another bedroom added to your home, or the three of them get into Harvard in 2019, you might consider home equity to get you over the hump. But only if you are in excellent financial health, with no other debt, money in the bank for emergencies and the discipline and resources to quickly pay back what you draw out.

-- Posted: Jan. 9, 2003

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