Should home equity be used to pay down credit card debt?

If you have equity (cash value in excess of loans against it) built up in your home, good for you! You’ve been doing a good job of managing your money in the homeownership department. And, you’re still coming out on top in view of the slide in home values. Therefore, you have the ability to borrow against what is likely your largest asset, your home, in two ways. You may choose to secure a home equity loan in a lump sum, or you may choose a home equity line of credit (HELOC) to draw from as you need it.

The difference between loans and lines:

Home equity loans are usually obtained by borrowing a fixed amount, for a fixed period of time, at a fixed interest rate. They are like a second mortgage.

HELOCs work more like a credit card. You work with your banker to establish how much of a home equity line you qualify for and use the money on an as-needed basis. Late fees can add up just like on a credit card so consider setting up automatic debits as a way to pay your home equity line back. In addition, it’s important to remember to pay back the principal. You will only be billed for the interest owed. While it is tempting to just make payments on the interest, HELOCs should be paid back. Otherwise, your safety net never gets restrung.

Adjustable interest rates are most common for HELOCs that are tied to the prime rate. Look for a HELOC that has a lifetime rate cap within your ability to repay. If the prime rate goes back up to double digits, your home equity line of credit payments would be adjusted upwards as well. Consider a fixed-rate HELOC to protect against rising interest rates. Also, look for HELOCs with no prepayment penalties.

There are ample good reasons to borrow against your home. They include the tax deduction on the interest you repay unless you use it for business or investments, interest rates are historically low at this time, home improvements may increase the value of your home and your family’s enjoyment, to fund education, or as a godsend for a medical emergency or unexpected event.

To use or not use to pay off credit card debt

The big question is should you use a home equity loan or HELOC to consolidate debt or pay off high-interest credit cards. First ask, how did you get into credit card debt in the first place? If it was unforeseen health issues, the loss of a job or other events beyond your control, then using your home as your bank may have been warranted. You will most likely have the discipline to repay the loans. However, if you overextended your credit cards because of out-of-control credit card use, old habits die hard. You may lack the restraint to rein in your expenditures, and your home could be at risk.

The dangers of debt consolidation:

Think twice before using the equity in your home for debt consolidation or to pay off high-interest credit cards. On the plus side, you are trading high-interest debt for lower interest payments, and you are trading nondeductible interest payments for tax-deductible interest. You might also improve your cash flow by having one payment to make and at a reduced amount.

The tradeoff for these attractive benefits is the precarious position you will put yourself in by exchanging your unsecured debt for secured debt, your home. An unsecured loan doesn’t put you in the street if you can’t repay it.

What if your income is reduced, you experience disability, the sole breadwinner dies, or human nature prevails and you start using the credit cards again? What if your home’s value falls below the amount of your line or loan? You’ll find yourself owing more than your home lien is worth, which is termed “upside down.” You could possibly lose your home.

Home equity loans and lines of credit have grown rapidly because of the need in these difficult economic times, low interest rates, and tax advantages. If used wisely, this is a good time to take money from your home to use it to pay off higher-interest credit card debt and as originally intended to improve the value of your home or some other well thought-out purpose. Examine your motives and safety net if you’re close to retirement so as to leave yourself financial flexibility and not jeopardize your security in your retirement years. And remember, whether it’s home equity lines or loans, it’s still your home that you are borrowing against.

There are also alternatives such as Lending Club which is peer-to-peer lending.  Many individuals have used companies such as this to consolidate high interest credit card debt at a lower rate in a quest to eliminate their credit card debt. 

Published 07/01/11 (Modified 07/07/11)