Pros of using home equity to consolidate debt By
George Saenz
• Bankrate.com
Most of us can run up credit card
debt without even knowing exactly how we did it.
We look at that statement with the big numbers and
try to remember where the money went. A few dinners here, some clothes
there, a short weekend getaway, late charges and, finally, over-the-limit
fees. Then add lots of interest that your parents used to be able
to deduct from their taxes but you can't.
What makes it worse is that when you're on a fixed
paycheck, it's difficult to pay off that debt incurred in good times
past. The best solution is to get a clean break by rolling that
debt into a home equity loan.
Why tap home equity?
Most home equity loans are taken either to:
- Make improvements that add to the value and enjoyment
of the home, or
- Refinance the good life that you incurred on the
plastic you carry in your wallet.
If you are borrowing to build a new kitchen, you feel
OK about the borrowing, since you know you're adding value to your
home. And if you end up with a new kitchen, perhaps you'll spend
less money in the long run on eating out.
However, when you're borrowing to refinance credit
cards and consolidate your other loans, the decision gets more difficult.
A lot of people find themselves with far more credit
card debt than they can handle. If you're in this situation, start
arranging to refinance the debt into a home equity loan.
In fact, if you're really feeling financially daring,
add enough money to get that boat that you couldn't get when you
were maxed out on the credit cards.
That's a joke, but this isn't: Remember that you're
already in debt with the credit card companies.
Refinancing's many benefits
Refinancing your debt into a home equity loan doesn't increase your
debt. It doesn't add a dime to what you already owe. It just moves
the debt.
By refinancing, you're shifting the debt from various
credit cards with differing due dates to one lender at a lower interest
rate with a fixed repayment plan. In addition to the convenience
of consolidating payments and payment dates, you create a tax benefit
like your parents had before 1987, when they could write off credit
card interest on their taxes.
The major downsides to this strategy are that it leaves
you with refreshed credit limits on the plastic that you carry in
your wallet and puts your home at risk if you don't pay. If you're
not careful, you will wind up facing the same problem down the road.
Actually, many years of practice tells me that most
people will wind up in the same place, since we don't change our
ways. However, at least by refinancing you've given yourself a break
and have for a period the psychological benefit of knowing that
you're credit card debt-free.
In addition, you'll have the financial benefit of
paying a lot less interest, not to mention the cash you'll save
by making the interest expense tax deductible.
And you'll also probably think harder about what you
charge on your cards, so you don't have to face this decision again.
When you get set to refinance you'll want to find
the right loan and also set a timetable for having the loan paid
off as soon as possible. When I say getting the loan paid off as
soon as possible, I mean at least paying off the old debt before
you rack up another round of credit card debt that you'll need to
refinance.
Home equity loan vs. HELOC
For this reason, I recommend that if you're refinancing
debt, get a home equity loan rather than a home equity line of credit
(HELOC).
A home equity loan is a fixed amount that you borrow
to be paid off over a certain number of months (I recommend 36,
and no more than 60 months).
A HELOC is like a bank account where you continue
to write checks on the equity in your home as opposed to writing
the checks based on actual money in the bank. A HELOC does not have
a period in which it will be paid off, since you can continue to
borrow against it, similar to a credit card.
Bankrate offers calculators
for figuring loan payments and can give you an idea of the
best interest rates in your area.
Before using these resources, you should figure out
how much debt you have. Also figure out how much you've been paying
every month on these revolving debts.
Let's say you have $25,000 in debt you've been paying
$500 to $600 a month on, and the amount of debt has been the same
for a while now. If you refinanced that into a four-year home equity
loan at 8.5 percent, your monthly payment would be $616 and you'd
get it paid off.
Of course, if you use your entire budget to repay
the home equity loan, it doesn't leave you any room for paying the
monthly minimum on future credit card charges. This means that those
payments will have to come from future raises or odd jobs until
you've paid off the old good times.
Use that tax break wisely
Actually, part of the payments should come from the reduced taxes
you'll pay as a result of deducting the interest on your taxes.
In the first year of the loan in our example above, the interest
paid works out to $1,915. If your combined federal and state marginal
tax rate is 33 percent, your tax savings will be $630, or a little
more than $50 a month.
That sounds like a monthly minimum payment on a new
round of debt to me. Of course, you could stop spending. But how
likely is that?
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