Using a Home Equity Loan to Pay Off Credit Cards Quickly
A trip to Las Vegas here, some new living room furniture there, with a couple of “I’ll pick up the tab” moments thrown in, and, before you know it, you’ve maxed out your credit cards. It’s easy to do, whether you’re using credit for casual use or supplementing your income. If you’re a homeowner who has reached the point where credit card debt has become unmanageable, a home equity loan might be the fresh-start solution you need. We’re weighing the pros and cons of using home equity loans to get out of debt quickly and taking a look at some other alternatives that might be a better fit depending on your financial situation.
What is a home equity loan?
A home equity loan is a secured loan that uses your home as collateral. It acts as a second mortgage with a set interest rate and fixed payments required every month. An appraisal is typically done to determine how much equity is in the home. If you know your home’s appraised value is $340,000 and you owe $240,000, you have $100,000 in equity. However, you won’t be able to access the entire $100,000.
“The amount that you can borrow usually is limited to 85 percent of the equity in your home. The actual amount of the loan also depends on your income, credit history, and the market value of your home,” said the Federal Trade Commission (FTC). You can calculate the equity you have in your home here by plugging in the appraised value of the home and what you owe on your mortgage.
Pros and cons of using a home equity loan to pay credit card debt
Using a home equity loan to pay credit card debt may allow you to get rid of multiple payments and lock in a lower interest rate.
Depending on the lender and the terms of the loan, a borrower can have funds in hand in as few as two weeks, although 30 to 45 days is more typical. Home equity loans may also be easier to qualify for if you’re in good standing with your lender.
Using home equity to get out of debt can seem like a no-brainer for those who can qualify and whose home value has grown, but it’s not without its drawbacks. Because a home equity loan uses your residence as collateral, your home may be at risk if you fail to make payments. You will probably also incur closing costs and fees with your new loan. They can range between 2% and 5%, although they can typically be rolled into your new loan so you don’t have to pay out of pocket.
Another potential disadvantage to using home equity to pay off credit cards quickly—and one that borrowers may not always consider—is the psychological impact. Wiping out a large balance may feel like an accomplishment, but, without a change in mindset, people may soon find themselves back in the same financial conundrum—or one that’s even worse, according to Bruce McClary, vice president of marketing for the National Foundation for Credit Counseling (NFCC) in Washington, DC.
“Some of the worst, nightmare scenarios I have seen are attributed to home equity payoffs that went wrong,” he said. “The worst thing that can happen is that people use their home equity to pay off credit card debt, and then run their balances back up to the top. They end up tapped out of all their home equity with all this high-interest debt without any options to pay it off quickly and affordably. I really caution people; there is a lot of rope to hang yourself when you use your home equity. You have to think it through and look at other options to accomplish your goal affordably while at the same time preserving your stake in home ownership by keeping your hands out of your home equity.”
Alternatives to using a home equity loan to pay credit card debt
There are several other strategies consumers can use to get relief from credit card debt, and each comes with its own set of pros and cons.
A personal loan may be the answer for those who need money quickly to pay off their debts. These loans can come from a bank or lender, with funds available in a matter of days, in many cases. Terms and rates can range dramatically for these loans and are based largely on your credit history.
One of the main advantages to taking out a personal loan is that, assuming the approval amount is high enough and the interest rate attractive enough, you can consolidate numerous credit cards into one payment at a lower rate, which will then lower your payment—and the amount of interest you’ll pay over the life of the loan. You’ll also have fixed payments with a set payoff date, so every payment is going toward dissipating the debt. This makes it a good option for those who are buried in high-interest credit card debt and who are not chipping away at their balance by making minimum monthly payments. Additionally, there is no collateral needed for most personal loans because they are unsecured. That means you won’t need to put up your house or car in order to get funding.
But, personal loans can also be burdensome. First, the interest rates, which can be as low as 6%, will be reserved for those with the best credit score. If your credit is already suffering, a personal loan with a rate that can be as high as 36% may not lower your monthly payment. As with home equity loans, borrowers who don’t change their behavior once the credit cards are paid off also run the risk of charging the balances up again. Being on the hook for a personal loan payment plus credit card payments wouldn’t be any fun.
Balance transfer credit card
Is your credit score still hanging in there? Balance transfer credit cards may be your best option.
“For manageable amounts of debt, I usually recommend finding a low cost (hopefully 0%) credit card with a low balance transfer fee, and then have the client pay off the debt within the 0% interest window of usually 12–18 months,” said Cheryl Ober, CFP®, of
Cheryl Ober Financial Planning, a Minneapolis, MN-based, fee-only SEC-Registered Investment Advisor. “If it isn’t paid off during the introductory rate and the client needs a little longer, they can roll the remaining balance over to a new 0% interest card.”
The appeal of balance transfer credit cards is the low (or nonexistent) interest rate for a set period of time, but that doesn’t mean the process is fee-free—nor does it mean the process it without its hiccups. “The problem with doing this is that, often, the clients have high debt ratios and may not be given a high enough limit on the 0% card,” said Ober.
When weighing your balance transfer options, be sure to find out:
- What is the interest rate?
- Is it a promotional rate, and, if so, how long does it last?
- What is the rate once the promotional rate expires?
- How much is the balance transfer fee? (This is typically 3–5% of your balance)
If you have equity in your home but don’t want to take out a second loan, consider a cash-out refinance. This means taking out a new loan, paying off your current mortgage, and rolling the available equity in your home into the new loan. The rate on your new loan may be higher than your current rate—especially if you purchased or refinanced over the last several years.
The combination of a higher interest rate and a higher loan amount that bundles your existing loan balance and the amount of cash you’re taking out to pay off your cards means you’ll have a higher mortgage payment. But, if the payment is still lower than what you have been paying for your mortgage and credit cards, you’ll still come out ahead. Your loan terms may also be different; this could be a good opportunity to move from an FHA loan to a 30-year conventional loan to get rid of Private Mortgage Insurance (PMI) and lower your payment.
Debt consolidation is a way to pare multiple debts and their corresponding payments down to one. Balance transfers, personal loans, and home equity loans can all technically fall under debt consolidation, but another type of program exists for those who may be out of more attractive options. Debt management plans are often used as a last resort for consumers who may not be able to get access to their home equity or get a viable personal loan because their credit score or income is insufficient.
Debt consolidation plans may cause a temporary drop in credit scores but the upside is that they can help consumers curb creditor calls calls, get out from under the stress of untenable debt, and also provide an opportunity to start over.
“By participating in this type of debt management program, you may benefit from reduced or waived finance charges or fees, and experience fewer collection calls. A debt management plan sets up a payment schedule for you to repay your debts, with the goal of helping creditors receive the money owed to them and ultimately improving your financial and credit standing,” said the NFCC. “It usually takes 3-5 years to complete payments under a debt management program, after which you may be able to reestablish credit.”
Having to take money out of a retirement account can feel like a step backwards. But, keeping money for the future when you’re struggling in the present may be counterintuitive. That being said, while there are benefits to being able to redirect these funds to pay off credit cards, the downsides often drive consumers toward other solutions. Namely: Consumers are wary of withdrawing their funds early because of the potential penalties and fees.
Traditional IRAs are not taxed at the time the money is collected, so early withdrawal triggers a tax scenario plus a penalty if the funds are withdrawn before reaching a minimum retirement age. Rules are different for Roth IRAs; you may be able to withdraw some funds tax-free, but there is a multitude of rules governing when, what, how, when, and how much.
Saving and budgeting
Might you be able to live more frugally, putting more money toward your cards in an effort to get out of debt quicker? With the right mindset and the right plan, it’s possible, according to Christiane S. Delessert, PhD, CFP®, for Waltham, MA-based wealth management firm, Montis Financial LLC.
“The alternative, more conservative solution, is to line up the credit cards and start paying off the one with the highest rate, which might require some ‘belt tightening,’” said Delessert. “The trick is to reduce all expenses and give priority to debt repayment. We run a cash flow analysis and estimate how long it would take to pay back the debt, and then it’s just about sticking to the program!”
The bottom line
A home equity loan is a great option for paying off credit cards quickly, but it’s only one of many. What works for one person may not be ideal for you, so it’s important to look at the advantages and disadvantages of each and consider both typical scenarios and what may be unique about your situation before committing to a financial plan or program.