People who feel overwhelmed with debt often spend sleepless nights wondering how to pay off credit cards, but there are a variety of debt consolidation options available. The key is to not only pay off existing debt, but to avoid creating further debt problems in the future.
Option 1: Cash-out Refinancing
One way to pay off credit cards is to refinance a mortgage with a new loan that is larger than the remaining balance on the mortgage. This is known as cash-out refinancing. Suppose a home owner owes $100,000 on a house worth $200,000. At the same time, that home owner has $20,000 in high-interest credit card debt. The home owner could refinance the property for $120,000, using $100,000 to pay off the existing mortgage and the remaining $20,000 to pay off the credit card balance.
Increasing the size of the mortgage may result in a larger monthly mortgage payment, but it would eliminate the monthly payments on the credit card debt. The main point is that since mortgage interest is much lower than credit card interest, this move should allow the home owner to save a significant amount in interest charges. This refinancing strategy is especially attractive if current mortgage rates are equal to or less than the home owner's existing mortgage rate.
Option 2: Home Equity Loan
If current mortgage rates are higher than the home owner's existing mortgage rate, it may not make sense to refinance the entire mortgage. Instead, the home owner should consider getting a second mortgage, borrowed against the equity in the home.
The extent to which a home owner can borrow against home equity depends on a calculation of the loan-to-value ratio (LTV), which compares the total amount mortgaged to the appraised value of the home. LTV ratios are usually between 80 and 100 percent, though keeping the LTV at 80 percent or below can help the borrower get a more attractive interest rate. What the lender does is multiply the LTV ratio by the value of the home, and then subtract the balance owed on the existing mortgage. The remainder is the amount that can be borrowed against the home's equity.
For example, if the home owner owes $50,000 on a home that has been appraised at $150,000, the following would determine how much can be borrowed:
Appraised value = $150,000
Appraised value times an 80 percent LTV ratio = $120,000
Subtract existing mortgage of $50,000 = $70,000
The result shows that the home owner could get a home equity loan for as much as $70,000.
Home equity loans usually have a fixed interest rate and level payments over a term of 15 years. Home equity loan rates are usually higher than prevailing purchase mortgage rates, but lower than personal loan rates. Also, since home equity loans are a form of mortgage, the interest payments are generally tax deductible.
A home equity loan differs slightly from a home equity line of credit (HELOC), which gives you access to credit on demand over time. However, since the idea is to pay off credit card debt immediately, getting a lump sum up front via a home equity loan is generally a better fit for this purpose than a HELOC.
Option 3: Personal Loan
Someone who does not have home equity available or does not want to borrow against it could pay off credit card debt with a personal loan. Like a home equity loan, this would provide the borrower with a lump sum to immediately pay off existing debts with, but unlike a home equity loan, a personal loan is not secured by a home. Because of this, personal loan rates are higher than home equity rates, but this option could still be beneficial because personal loan rates are generally lower than credit card interest rates.
How to Pay Off Credit Cards: Moving Forward
While any of the above options can solve the immediate problem of credit card debt, an important element moving forward is a budget discipline to avoid racking up further debts. Without that discipline, the borrower may simply add to existing debt problems until they become unaffordable, and if refinancing or a home equity loan was used, this could put the borrower's home in jeopardy. In short, these strategies help make debt more manageable, but it is then up to the home owner to manage it.