Lower payments and a tax break

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.

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.

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.

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.

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 7.23 percent, your monthly payment would be $601 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 $1,742. If your combined federal and state marginal tax rate is 33 percent, your tax savings will be $575, or $48 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?

If you decide to take out a home equity loan, begin by using Bankrate’s rate comparison tool.