If you own a house and have credit card debt, you may be considering using a home equity line of credit (HELOC) to pay off your credit card debt, and with a lower interest rate.
When you take out a HELOC, you open up a revolving line of credit from your mortgage lender where your home serves as collateral. Lenders typically set your credit limit by taking a percentage of your home’s appraised value and subtracting the balance of your existing mortgage. Unlike a home equity loan, where the borrower receives a lump sum, a HELOC is available when you need it, similar to a credit card.
Equifax data shows that many consumers are using HELOCs. More than $120 billion worth of HELOCs were originated in 2014, a year-over-year increase of 21.5 percent—and the trend is expected to continue.
If you’re one of the many consumers considering using a lower-interest HELOC to pay off high-interest debt, such as credit card debt, here are a few things to consider.
Revolving credit with a low interest rate. Because a HELOC is secured against the property, it typically carries a lower interest rate than unsecured debt, such as credit cards. Taking out a loan, such as a HELOC, to pay off credit card debt could save you money on interest and lower your monthly payments.
Fewer creditors to pay. If you have multiple credit cards with outstanding balances, a HELOC could help you simplify your bills. You will be able to use the financing from the HELOC to pay off your credit card debts. Instead of paying several creditors each month, you would make an extra payment to your lender to repay the HELOC.
Tax deductible. The IRS allows you to claim the interest you pay on a HELOC as a tax deduction if the size of your HELOC is less than $50,000 (or $100,000 for couples filing jointly).
Loss of the home if the debt goes unpaid. After you pay off your credit card debt, you still have to pay back your lender. Your interest rate may be lower, but if you are unable to pay off the HELOC, the lender may be able to force you to sell your home to satisfy the debt.
Principal lingering after repayment. Some repayment plans set a minimum monthly payment that includes a portion of the principal (the amount you borrow) plus accrued interest. However, the portion of that set payment that goes toward principal may not be enough to repay the principal by the end of the term. Other plans may allow payment of interest only during the life of the plan, which means that you will pay nothing toward the principal. For example, if you borrow $10,000, you will owe that full amount when the “repayment” plan ends—and you could be forced to pay it all at once.
Risk if the home depreciates in value. Homeowners never want their mortgage to be under water, meaning they owe more money than the house is worth. To avoid this, lenders require homeowners to maintain a certain level of equity. For instance, some lenders might require homeowners to have at least 10 percent equity in their home after taking out a HELOC, so the most they can borrow is 90 percent.
Take time to shop around for credit terms that best meet your borrowing needs, as a HELOC could include extra fees, such as property appraisal fees, application fees, and closing fees. Additionally, HELOCs often have variable interest rates, so be sure to understand how high your monthly payment can go before you make a decision.
Finally, be sure the HELOC isn’t just a temporary fix. If you use it to pay off credit card debt but don’t change your spending habits, you could end up in a worse situation than before. You may want to speak with a HUD-approved housing counselor or a financial advisor before taking out any equity in your home.
Susan Johnston has covered personal finance and business for publications including Bankrate.com, The Boston Globe, Entrepreneur.com, Learnvest.com, Mint.com, and USNews.com. Find out more at www.susan-johnston.com.
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