Home equity loan Options
Should You Pay Off Credit Card Debt With a Home Equity Loan?
When you pay your bills every month, you may be reminded of something that you'd rather forget: you have built up a large credit card debt. Every month you struggle to pay the minimums and don't like the fact that most of what you pay goes to satisfy the high credit card interest rate. You see that no matter how hard you try to economize, that stubborn credit card debt keeps draining your hard-earned income.
Is there a way to eliminate your credit card debt? If you own your own home, you may have thought about using your home as equity to pay off credit card debt. The logic seems attractive: if you can pay off a high-interest loan (your credit cards) with a low-interest loan (a home equity loan), you'll be able to save money and pay down your debt faster.
Do the Math
The logic sounds good, but you need to run the numbers. Let's start with your credit card(s). For simplicity we will combine all of your cards into one debt and one average interest rate.
Credit card debt:
- You owe: $10,000
- Interest rate (APR): 20%
- What you can pay per month: $175
- How long it will take you to pay off your credit card debt: 15 years (180 months)
- Total you will pay: $31,500
Now let's say you can take out a home equity loan for $10,000. Here are some typical numbers. Based on your credit score, your interest rate may by higher or lower.
Home equity loan scenario:
- You owe: $10,000
- Interest rate (APR): 7%
- Term: 15 years (180 months)
- Monthly payments: $90
- Total you will pay (not including fees): $16,200
It looks like an easy decision. By taking out a 15-year home equity loan for $10,000 and using the cash to pay off your credit cards, you cut your monthly payments almost in half.
If you pay off the home equity loan at the same rate that you have already been paying your credit card debt ($175 per month) you will pay off your home equity loan in only 70 months, or a bit less than six years. After six years you could take that same $175 per month and invest it at a 5% return. At the end of eight years (which is the end of your original 15-year home equity loan period) you will have over $24,000-almost double the amount you invested!
The Risks of a Home Equity Loan
The main thing to consider when shifting debt from credit cards to a home equity loan is that credit cards are unsecured loans, while home equity loans are secured by collateral - your home. You need to consider several risk factors:
- Is your income secure? Do you have savings? What would happen if you lost your job or suffered a cut in income? If you default on your home equity loan, your lender could foreclose on your house. If you default on your credit card payments, the credit card company can make your life miserable by damaging your credit rating, initiating collection action, and calling you on the phone. But they cannot take your house.
- How much equity is in your home? If your home is appraised at $250,000 and you are paying a first mortgage, check how much principal you owe. Let's say you've been paying for five years and you still owe the bank $200,000. The equity you have is $50,000. The bank calculates the loan-to-value ratio to determine how much it will lend you. If you have good credit, a bank may use an 80% LTV, which would be 80% of $55,000, or $40,000. This will be more than enough to cover your $10,000 credit card debt.
- Don't forget to consider the bank's loan fees. If the difference between paying off your credit cards and paying off a home equity loan is slight, then add in the loan fees - they may tip the balance away from the home equity loan.