Cons of using home equity to consolidate debtBy
Dorothy Rosen
• Bankrate.com
Keep your cotton-pickin' paws off your nest egg.
Using home equity to pay off bills and make major
purchases always looks good on paper; that's why so many folks are
doing it. How can you argue with lower monthly payments, tax-deductible
interest and no more credit card debt? It's easy when you're the
Dollar Diva.
Lower monthly payments
If you're a typical American consumer, you have too much high-interest
debt, and it's costing a bundle to service it. When a lender offers
a chance to lower those monthly payments with a low-interest, home
equity loan or a cash-out refinancing, it can feel like manna from
heaven. But don't kid yourself; no one's passing out free lunches.
When you tap home equity to pay off bills, you kiss off those high
monthly credit card payments, but you don't kiss off the debt.
The lower monthly payment makes the debt look harmless.
Look closer and behold the same old wolf; he's just decked out in
grandma's bonnet. Even though the interest rate is less and the
monthly payments are low, you usually end up paying more over the
long run because the payments are stretched out over a longer period.
When debtors use home equity to pay off their bills,
they usually swear to God they'll never carry a credit card balance
again; but they forget to change their spending habits, and they
forget to save for emergencies and big-ticket items. When the car
needs a new transmission, or they "need" a vacation, the
plastic get resurrected and the debt cycle resumes.
Tax-deductible interest
Tax-deductible interest is the war cry lenders use to prod unwary
homeowners into using their precious home equity to fund major purchases
and pay off debt. It sounds good until you start running the numbers.
Let's pretend you have $40,000 in 18 percent credit card debt; your
current monthly payment is $1,000. Continue the $1,000 payments,
and the debt is history in 62 months. Total payments will be $62,000
($1,000 x 62) and total interest will be $22,000 ($62,000 minus
$40,000).
Use a 9 percent home equity loan to stretch the payments
out over 180 months and payments go down to $406. Total payments
will be $73,100 ($406 x 180) and total interest, $33,100 ($73,100
minus $40,000); you'll pay $11,100 more interest with the home equity
loan. If you're lucky, the tax deduction will compensate for the
extra $11,100, but don't count on it. The lenders are the only ones
who can bank on making big bucks on home equity loans; that's why
they spend big bucks marketing them.
No more credit card debt
Tapping home equity makes it easy to get rid of credit card debt,
but that state of bliss is usually fleeting. Why do folks rack up
so much credit card debt in the first place? Could they be living
beyond their means? Most folks who use debt to get rid of debt forget
to change their negative spending habits and end up deeper and deeper
in the hole.
Home equity loans can be expensive
Home equity is something to cherish and preserve,
not deplete. Here's what no one tells you when you sign off on that
home equity loan:
- Home equity is a time-proven way to accumulate
wealth and provide a sense of security; when you tap it to pay
off bills, you become poorer.
- Use home equity as a money tree and you could end
up paying private mortgage insurance (PMI) forever.
- Credit card companies can't foreclose on your home
if you run into financial difficulties. But home equity loans
and cash-out refinancings are debts that are secured by your home.
If you can't make the payments, you risk living in a corrugated
box.
- How about those loan origination fees and prepayment
penalties?
Conclusion
For most folks, the road to getting out of debt and achieving financial
independence is paved with discipline and belt tightening, not more
debt. Debt paves the road to bankruptcy court. Here are some tips
to help you get on the high road -- to financial freedom:
- Spend less than you earn, and save the difference.
- Resolve to be debt free, and lay out a strategy
to make it happen.
- Invest in yourself -- you are a money making machine;
the more money you make now, the quicker you'll achieve financial
independence.
- Keep your cotton pickin' paws off the equity in
your home.
Postscript
As a general rule, tapping home equity is a no-no; but where is
it written you can never break a rule? If you give birth to triplets
and need another bedroom added to your home, or the three of them
get into Harvard in 2019, you might consider home equity to get
you over the hump. But only if you are in excellent financial health,
with no other debt, money in the bank for emergencies and the discipline
and resources to quickly pay back what you draw out.
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