Wednesday, February 26, 2014
Home Equity Pitfalls
by Frances Rahaim, Ph.D.aka "The Money Doctor"
Think you’ve found the answer to your credit card debt problem in the equity of your home? Before you take out a home equity loan (HEL) or line of credit (HELOC) and roll your credit card debt into it, there are a few things you may not have considered, but which should not be underestimated.
I, too, once believed the propaganda encouraging the use of your home’s equity to restructure your credit card debt.
“Save thousands of dollars in interest. Pay lower monthly payments, deductible interest.”
Sounds great, right? Here’s a list of the things I think most people miss when considering this tactic:
1. The credit cards are paid off (restructured) with a HEL, but nothing substantial has been done to arrest the actual problem. This is a case of treating the symptom rather than the cause. Folks absolutely believe they will just “not charge anything on credit cards anymore.” It’s likely that if habits don’t really change, and income doesn’t actually increase, this will be just a temporary solution.
2. Many people plan at the time of taking out the loan that they will continue to make the same monthly payment they used to make to credit cards to the home equity loan. The reality is that very few people continue to do that consistently, month after month for years, despite best intentions. Most often, borrowers settle into a lower payment and breathe a sigh of relief – for a while. The fact is that the credit card payments were causing discomfort, which is what inspired the idea of transferring the debt to begin with, and any future increase in expenses causes a decrease in that loan payment — and the cycle continues.
3. That brings me to my next point, which is that a staggering number of people who have taken this route end up back in credit card debt on top of the second mortgage they’ve taken to pay the first batch of debt. Now, with little to no equity left in the home, if finances get tight, there may be nowhere to turn.
4. To make matters even worse, my biggest objection is that they’ve now put their home at risk for debt that was previously unsecured. In other words, if they fell into financial trouble while the debt was owed to credit cards, (unsecured), the lenders are in an weaker position, meaning that no collateral secures the loan, so their only recourse is to file suit for judgment. They know that a bankruptcy could wipe out credit card debt, but once they’ve used their home to pay credit cards off, they have now turned that same debt into secured debt. Home equity loans and lines of credit are mortgages and would not likely be dischargeable in a bankruptcy. Now, if they cannot meet their monthly obligations, they risk foreclosure. Unless you have a reliable crystal ball, that may be a big risk to take in return for some interest saved.
In my opinion, home equity loans and lines of credit should be used for debt related for the home. Need a roof, kitchen or septic system? A HEL or HELOC may be the answer. But for credit card debt there are many other options. Of course, there are exceptions to every rule, but perhaps this list will help you have an open discussion with your banker if you are considering applying for a second mortgage or line of credit.
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