Are your credit card bills keeping you up at night? If you are a homeowner with some equity, a home equity loan to consolidate your debt could be a savvy move to get you on firm financial footing again.
When you consolidate your debt via your home equity, you take out a home equity loan to get a lump sum of cash. You can use the cash to pay off your consumer debts, so the home equity loan--often referred to as a second mortgage--effectively replaces your various consumer loans.
However, consolidating your debt with your home equity is no silver bullet. It will not magically make your debt disappear, nor will it put you in a better financial position if you have bad spending habits that you don't get under control.
4 reasons to use home equity for debt consolidation
Here is what debt consolidation with home equity financing can do for you:
- Make things simple. You will be replacing several monthly payments with one, making repayment easier to manage and late fees a thing of the past.
- Slow the growth of existing debt. Interest rates on second mortgages are typically far lower than consumer credit rates, since your mortgage is secured by your home as collateral. A lower interest rate means your existing balance won't be growing as quickly.
- Reduce monthly payments. Whether through a lower interest rate or a longer repayment period, you can lower what you pay each month toward your consumer debt. (Debt consolidation will not necessarily reduce the interest paid over the lifetime of the loan, however. In fact, it is important to note that debt consolidation can cost you as much or more in total repayment costs, particularly if you stretch out the repayment period.)
- Allow you to deduct more from your taxes. Mortgage loan interest payments are tax deductible, but consumer debt interest payments are not. Consolidation with a home equity loan can reduce your federal income tax through an interest-paid deduction on Schedule A.
Example: home equity loan vs. credit card debt
Let us say you have $25,000 in credit card debt at 18 percent interest, and you are currently paying $400 a month on that debt. A credit card payoff calculator shows that it would take over 15 years to pay off that debt. In the course of repayment, you'd pay more than $49,000 in interest.
If instead that $25,000 were owed on a home equity loan at 8 percent for 15 years, a mortgage calculator shows that your monthly payment drops to $239, and the total interest paid over the 15 years would drop to nearly $18,000.
If you needed to reduce your monthly payments even further, you could choose a home equity loan with a 30-year repayment period. Your monthly payments on the debt would fall to $183 per month, but the longer payback period means your interest payments increase to over $41,000 (almost as much as the total interest paid on the credit card debt at 18 percent over 15 years).
To become debt free the fastest, you could lower your interest rate with the home equity loan and keep paying the original $400 monthly payment. It would take just six years and 10 months to pay off your debt.
Avoiding the debt consolidation trap
Some advertisements make it seem so easy to fix your credit problems by consolidating debts with a home equity loan. But experts estimate the failure rate for such programs at an astonishing 66 percent to 80 percent.
Even the best home equity loan in the world will not tackle what got you into debt in the first place. Successful debt consolidation requires you to change your spending behaviors. Consolidation makes your debt easier to pay off, as long as you stop outspending your income.
If spendthrift ways are at the root of your debt, try the following strategies as you consolidate with a home equity loan:
- Limit your credit card use. Cancel your cards if you can't stop overspending, or keep only one for emergencies and have someone you trust hang onto it for you.
- Get professional help. Find a reputable credit counseling service which can help you learn to budget and become accountable for your spending choices. Avoid any agency that wants to put you into a debt management plan (you do not need it if you are doing it yourself with the home equity loan) or push you into debt settlement, especially if they want a large sum of debt repayment money from you upfront. What you are looking for here is free or low-cost education and counseling.
- Set up automatic payments. To reduce temptation, automate as many of your bills as possible. Arrange your checking account so that your first and second mortgage are paid automatically each month. Also, set up direct deposit and an automatic transfer of money to savings as well.
When a home equity loan is not an option
Not everyone has enough equity in their home or good enough credit to qualify for a home equity loan. In that case, try these solutions:
- Call your creditors. Many creditors will lower your interest rate in exchange for you freezing your accounts and not using them. Then set up automatic monthly payments from your checking account. Redirect any extra funds toward the account with the highest interest rate until it is paid off. Then, tackle the next highest, and so on.
- Enter a debt management plan. A debt management plan (DMP) from a credit counselor might be a good solution for you. Before signing up, understand how much of your monthly payment will go to your creditors, and get in writing how long it will take for you to become debt free.
- Weigh the bankruptcy option. If your debts cannot be paid through a DMP in five years or less, consider talking to a bankruptcy attorney. A Chapter 13 plan is like a DMP, except it is the bankruptcy court that has the authority to lower your payment to a manageable level. In five years, your debt is discharged even if you could not pay it all off.