With a fixed income, rising living costs, and unexpected expenses it is easy to see how credit card debt can accumulate. As balances go up, credit card payments start increasing. This puts a further strain on the monthly budget – causing even more dependence on credit to cover basic expenses. How the debt was created doesn’t even matter at this point. What matters now are the changes you make in order to get out of and stay out of debt. Home equity can seem like a quick solution to all of your credit card debt problems. But before you tap into your equity to repay your debt, here are some things to consider…
Using debt to pay off debt
When you hear advertisements about reverse mortgages, home equity loans, or cash out refinances you often hear phrases like, “you can use the money to pay off credit card debt.” This gives the perception that you are “paying off debt”. The truth is you are taking out a loan and using that debt to pay on other debt. So when you draw equity out of your home with a loan and use it to “pay off credit cards”, you are just moving debt from one place to another and your debt load actually stays exactly the same.
Securing the unsecured
Credit cards are unsecured debt, meaning that they are not secured with collateral like a mortgage or an auto loan. If you become overwhelmed with unsecured debts you have options like a Debt Management Program, internal hardship programs offered by creditors, or even bankruptcy as an absolute last resort. However, if you draw $20,000 of equity from your home and “pay off” your credit cards with it, you still owe the $20,000 but it is now a secured debt against your home. If you can’t afford to make your home equity loan payment, it’s just like missing first mortgage payments; missed payments could put you at risk of losing your home to foreclosure. And if you use a reverse mortgage to get that $20,000, it is a secured debt against the home that will continue to grow as interest accumulates.
Run the numbers
The interest rates on mortgages and home equity loans can sometimes be far lower than that of your credit cards. But keep in mind you will be repaying this debt over 15-30 YEARS. You most likely will also be paying closing costs to the lender that can be in the thousands of dollars. Explore all of your options for lowering the interest on your credit cards and then run the numbers on the closing costs and amortization of that interest over time. If it is a cash out refinance, make sure that you are taking into account the interest rate and the new higher mortgage balance. That way you can make sure that you are really are saving money. Let’s go back to our $20,000 of credit card debt example…
If you get a home equity line of credit for 15 years at 4.5% with $3000 in closing costs you would pay around $8670 in interest. If you have an existing $120,000 mortgage and do a cash out refinance with $4000 in closing costs and a 4% interest rate, adding that additional debt to the mortgage will end up costing you about $17,250 over the life of the loan. So compare that to what you might pay on a Debt Management Plan (DMP), where your unsecured debt would be paid off in 5 years or less. In most cases you’ll likely find that a DMP will save you more money in interest.
So, just make sure you do the math before tapping into your home equity. What seems like a bargain right now likely won’t be in ten years if you’re still paying off that loan or accruing a larger balance on a reverse mortgage.
If you want to know more about options for your credit card debts, contact LSS Financial Counseling at 1-888-577-2227 or visit us at www.ConquerYourDebt.org. You can also visit www.NFCC.org for a list of NFCC certified Credit Counseling Agencies. The certified counselors at these agencies can talk through all of your options for the debts, help you to build emergency savings to prevent future dependence on credit, and connect you with resources and benefits in your area that you may not be aware of.
Author Ashley Hagelin is a Financial Counselor at LSS Financial Counseling and specializes in Housing and Reverse Mortgage.