You dread going to the mailbox and answering the phone. Each paycheck seems to be gone before you’ve deposited it, and still you can’t seem to tame the enormous balances on your credit cards. Between the high interest and the balances you are carrying, it seems as though you will never dig yourself out of this financial mess. If you own your home, getting a home equity loan to pay off your credit card debt may seem like a no-brainer solution to your problem. There are certainly individuals who have successfully pulled themselves out of debt using their home’s equity. But this solution is not an all-purpose panacea and could potentially land you in even worse financial trouble.
It’s important to understand what exactly you would be doing by using your home’s equity to pay off other debt.
To start, it’s important to understand what equity actually is. This figure is the difference between what your home is worth and how much you still owe on the home. So if you have a home you purchased for $150,000 and you currently owe $110,000 on your mortgage, you have $40,000 in equity in your home. Before you start thinking that you can tap all of that $40,000, remember that it’s not always easy to get a home equity loan, and banks do want to see you keep some “ownership” in the house.
You also want to remember that your home equity loan and your credit card debt are two very different types of debt. The home equity loan is what’s known as secured debt, which means that it is financially backed by an asset — your house. Should you default on the loan, the bank can seize your house in order to get its money back.
Credit card debt, on the other hand, is unsecured debt. There is no particular asset associated with the debt, so the lender cannot reclaim property from you in the event of default.
If you were to use a home equity loan to pay off a credit card, you would be trading unsecured debt for secured debt, which can be very problematic.
Say you get the loan from the bank and immediately send the money over to your credit cards. What you do next can determine whether this was a great idea or a terrible mistake. If you don’t sit down and make a budget you can stick to, cut up or hide your credit cards, and seriously change your spendthrift ways, you’ll find yourself back in the exact same debt situation, except with no more equity in your home. Without addressing the underlying reasons for your original debt, using your home equity to pay off that debt will only land you in a worse mess.
Don’t forget that defaulting on the home equity loan could mean that you are homeless in addition to up-to-your-eyeballs in debt.
On the other side of the coin, if you use this opportunity to get your financial house in order, there are some definite pluses to using secured debt to pay off the unsecured debt. Interest rates on home equity loans will definitely be lower than the exorbitant rates your credit card companies are charging you, so the money you borrow is ultimately much cheaper.
In addition, that interest is generally tax deductible, just like mortgage interest, which means more savings when April 15 rolls around.
Using a home equity loan for this purpose can be a very risky move. Only you know if you have the discipline and desire for change necessary to make this work. If you can’t live without credit until the home equity loan is paid, then find another way to pay off your debt. Losing your house is not worth it.