Are you swamped with high interest debt and looking for a solution? The airwaves are filled with ads for debt consolidation, but do you really need someone to do it for you? Why not do your own legwork and roll your debts into one low(er) interest loan?
One option for consolidating your debt is rolling it into a HELOC. But first… You might have some questions.
What is a HELOC? Is consolidating debt with a HELOC a financially sound decision? What problems might arise if you use your HELOC to reduce your debt?
What is a HELOC?
The term HELOC is shorthand for “home equity line of credit.” Home equity is defined as the difference between what your house is worth and what you owe on the mortgage. This home equity line of credit essentially let you borrow money using the equity in your house as collateral.
Lenders typically calculate the line of credit based on a percentage of your home’s appraised value. For example, if you have a house that is appraised at $200, 000 and your principle is $135, 000, he lender may calculate your home equity line as:
$200, 000 * .80 (it varies among lenders) = $160, 000
$160, 000 – $135, 000 = $25, 000 HELOC limit
The percentage of your home’s appraised value depends on the lender, but it’s generally 75-80%. With houses appraising for much less than they used to in some areas, many homeowners have had their HELOC reduced or closed.
Why you should use a HELOC
The big plus with using your home equity line of credit to consolidate your debt is that you’ll almost certainly reduce the amount of interest that you’re paying. Since it’s a secured loan, your HELOC will typically will have a much lower interest rate than your credit cards.
If you’d like to play around with just how much you can save, I highly recommend the online calculator over at Dinky Town.
Another good reason to use a HELOC is that, assuming you itemize you tax deductions, the interest on your HELOC is tax deductible. Thus, you’re not only paying much less in interest, but you’re also catching a tax break, thereby reducing the cost further.
Why you shouldn’t use a HELOC
The other side of the coin when using a HELOC to consolidate debt is that you’re taking unsecured debt (credit cards) and tying them to your home. This can be a risky bet – what happens if you lose your job and can’t pay your HELOC? You risk losing your house, that’s what.
Also, getting a HELOC isn’t necessarily cheap. There are several possible fees associated with it that add to the total cost. Some of the fees you might face include:
- Appraisal fee
- Application fee
- Annual fees (some, not all lenders charge this)
Ultimately, you’ll have to weigh the costs of opening an account against simply using a debt snowball, or similar approach, to get out of debt.
It’s also worth noting that lenders have gotten much more strict when it comes to approving loans, so if you’re looking at getting one, be sure that you can qualify.
Another minor downside is that when you apply for a HELOC, they’ll do a hard credit inquiry which can hurt your credit score. It’s not much of a hit, but it’s worth keeping in mind.
Thoughts on using a HELOC for debt reduction
In my opinion, if you can get yourself out of debt in two years or less, I wouldn’t bother with a home equity line of credit. If you’re struggling with high interest rates, try negotiating with the credit card companies or look into doing a balance transfer to a card with lower interest.
Personally, I’m not a fan of converting unsecured debt (credits cards) to secured debt (HELOC). Yes, you can save money, but… With people getting laid off and paychecks being cut, your plans could fall through and you could lose your home.
There are other options besides using a HELOC if you’re looking to consolidate your debt. For example, you could try to get a personal loan through your bank or credit union, or you could consolidate your debt with a loan from Lending Club.
Your take
Have you ever used a HELOC to consolidate your debts? How did it work out for you? Would you do it again? Why or why not?
I used a refinance to pay off debt. It also reduced my intrest and shaved time off my loan. We had been making progress until the credit card laws changed, minimum payments went up, and I had to through my snowball out the window. All debt, including the car, will be rolled into this one payment with significantly less intrest. We’ve also opened up enough cash flow to pay it all off another 5 years earlier.
I can see that some people may take a second out on there houes to get out of debt but I don’t really think that it is a good idle, to do that now. We are in uncernty times and don’t know what is going to happen.
For the ones that would like to get out of debt on there own come see my website at debttowealth.weebly.com
We opted to refinance and pull equity out of the house that way instead of with a HELOC. At the time we were refinancing anyway and I knew we needed to replace our roof sooner than later. We ended up keeping the money in a separate account until we were ready and did like Floridan did and booked a contractor at a good time for both of us. Plus, we got a life-time roof and literally 6 times the insulation. We still have some left over that I’m keeping in our “pay our mortgage” emergency fund that will protect our house if one of us loses our job.
While I don’t advise others to do what we did, it worked for us. Have others pulled money out of their home as an emergency fund before? Is this a seriously flawed plan? With the tax deduction and the low interest rate (4.75) it seems better to pad our emergency fund than plow the extra into our mortgage.
If you plan to use a Heloc to consolidate consumer debt, I think there are a few guidelines that should be met:
1: Your credit card balances need to shrink for at least 6 months – 1 year before taking that step. If the balances are holding steady or increasing, the problem is not the debt, it is still the debtor. Even better would be to stop using entirely any credit card which carries a balance.
2: There needs to be a significant interest cost savings that is guaranteed for most of the pay-back period. If your card is charging you 15% interest, but your credit score is bad enough that the bank wants 10% on the Heloc, you may not be saving enough to justify the risk to your home.
3: Do a net worth analysis, there needs to be significant improvement over time to justify the risk. If you have cash flow issues and you aren’t gaining ground, a Heloc will probably give false financial freedom and land you even further in the red.
You have to prove to yourself that you have fixed the spending problem without question before you should entertain the idea. If you are “freeing up credit” or attempting to improve your credit score with this move, it’s the wrong decision. The dominant goal must be to decrease your total interest cost and never let it get back to where it currently is.
I believe if you have that much credit card debt, your out of control with your spending. That problem is you primary concern. Get that under control first. Rolling your cards into a HELOC is a disaster. I did it and just ran my cards up again. Thankfully the second time I learned and got an extra job to paydown my cards. I refinanced and rolled the HELOC into my mortgage. Thanks for this post. Getting an extra job solved my problem.
I agree with Nickel’s point that one of the biggest concerns with using a HELOC to pay down consumer debt is that people have a tendency to run up their credit cards again and then they end with both credit card and HELOC debts. Unless you fix the underlying spending problem first and can stick to a good budget then shuffling around your debt won’t help in the long run.
eh – it was still very hard to add debt to the house, even though we were using the funds to add value/space to the house.
Thanks for the website, Leen! congrats on the new debt free car! 🙂 We just paid off the car note on the 2008 SUV and plan to never have a car note again 😉 (only things we have to pay off now are the HELOC and the mtg!) My brother’s wife (same one that racked up all that CC debt) has the same car as mine, but a year older – she still has 3 years of car payments left. I can’t believe they even offer 6 year financing for cars!
Floridian – what you did is the only sensible use of a HELOC in my opinion because you added value to your house. Gail from Til Debt Do Us Part is awesome!! And she has an awesome website if you have never gone there – gailvazoxlade.com. I am lucky that my only debt right now is my mortgage (we just bought a new car (a really cheap one they were selling off pontiacs) with cash) so I don’t have to make these decisions.
exactly Leen and Nickel! My brother just did that for his wife, who had over $20K in cc debt that she told him about the day after they got married! Personally, I would have been trying my best to keep all assets and debt separate after that revelation!! But he refinanced HIS house, using HIS equity to pay off all HER debt – and she just went out and starting spending more when she all of a sudden had all her credit lines “freed up.” Just because it’s been rolled up into a mortgage doesn’t change the fact that it’s still consumer debt!
Leen – send that woman from “Till Debt do us Part” down south – I think my brother and his wife are gonna need her!!
Aside from the possibility of losing your house, a big concern for me is that people will move their cards onto a HELOC and then build up another boatload of debt on their cards.
I’m with Floridian – no turning unsecured debt into secured debt. That just puts you in a position of having more to lose.
And truthfully, if you’re the kind of person who gets into that debt in the first place, you’re vulnerable – either because of a personality flaw or because you’re in a vulnerable situation (no health insurance, unstable job, unstable family life) and adding in the HELOC just puts your home at risk too.
I would find it really tough to use a HELOC. After every mortgage payment I’m like woo hoo I have $107 more equity in my house. To give up my equity would be hard. Plus, losing your house is really possible. I couldn’t put more debt on my house. I know I might save more money with the HELOC but I would rather just throw myself at the debt with gusto. I know up here in Canada where I am from alot of people consolidate their consumer debt right into their mortgage. Once it is gone they forget about it and just start using their credit cards again and end up with the debt back on their cards and an extra $30000 on their mortgage. It’s a tough call.
Not to consolidate debt – I’m not a big fan of converting unsecured debt to secured debt either (did you also mention that most HELOCs are adjustable rate – another risk). But we DID take out a HELOC to finance a portion of the addition we built onto our house just over a year ago. We were saving with the intention of paying cash for the addition, but contractors got so desparate and were quite literally begging for work – prices were SO low. We figured it was a good time to get a top of the line contractor for dirt cheap! So we built the addition and got a new roof, and paid for part of thw work with a HELOC loan. The credit union offered a HELOC at prime minus 1 (but with a floor of 3.5%), with NO (zip, zero, nada) closing costs! What was funny is that we took out this HELOC at a time when it seemed EVERY one else was whining about how they could not get any credit. We not only got credit, but they were so excited to see someone actually qualify that they came to our house after hours to close the loan! We were shocked when they offered to do this upon hearing our schedules were so hectic that we’d have to come in one at a time to sign the closing docs. What service! I joked that we should have asked if he could bring dinner also 😉 hehe…but back on track….
Even though it put us further in debt for the moment, I felt it was a good move at the time. We got 20% more square footage added onto our house by THE best contractor in the city (literally!), and a HELOC for almost nothing. The same contractor is now so busy that his prices have nearly doubled (there’s no way we’d get the same amount of work done for so cheap without sacrificing quality now!). Additionally, the contractor (a certified green contractor, or something like that) made changes to our house and roof structure that caused our utility bills to go DOWN by about 20% (even though we increased our square footage by 20%)! IMO, that HELOC paid for itself and then some! (and, we’ll have it paid off no later than 2011). We have thoroughly enjoyed the extra space and are so glad the crappy economy allowed us to do it almost 2 years ahead of schedule!
Now the question is…do we pay off the remaining balance of the HELOC with money from our EF? We can do it, but it will leave us with less than $10K in the EF. There’s still almost 4 years left on the draw period for the HELOC, so we COULD draw funds back out in an emergency (which, I admit, is almost as bad as using credit cards in an emergency). But what are the chances that our HELOC will be closed completely if we pay it off now? Seriously considering paying it down to about $2 or $3K now, but worried they’ll decide to decrease the available line of credit if we do that…