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Is Using Home Equity to Pay Off Debt a Smart Idea?

Lately, with Your Money Line, I’ve found an increasing amount of participants in search of creative ways to pay off their debt. As of late, the most popular option seems to be using equity in a home to pay off other obligations. The justification for using equity to pay off debt is almost always the same. 

“Why would I pay my credit card company 21% interest when I could pay 5% or less on the same total debt amount?” 

Though the justification is always similar, the most important component of the scenario is never the same.

“How did you get to where you are now?” 

You see, collectively, you’re right. It simply makes mathematical sense to pay single digit interest instead of double digit rates. But, what good is this interest rate saving if it isn’t coupled with a change in behavior? The goal is to first change the “why” which lead you to the point of pulling money out of an asset you already planned on spending three decades paying off. 

I favor the concept of earning the right to refinance or to take a home equity loan. I want you to evaluate your spending, set up and stick to a budget, and then review said budget on a bi weekly or monthly basis. Sticking to this budget for a few months will help start you on a path to making sure you don’t again find yourself in this position. 

By using the equity in your home to pay off credit card debt you are replacing an unsecured debt (a debt with no collateral) with a secured debt (a debt backed by an asset). The interest rate decreases significantly between these types of debt because the financer now has the ability to seize an asset in the event you do not make the payments. This should not be taken lightly as a lack of change in behavior could put your home at risk for foreclosure. 

Now, let’s say you’ve “earned the right” to look at options for removing equity from your home. You are positive you corrected the behavior which lead you to this place. What do you need to know about your options? Where do you start to look? The following are the two most viable options and some major differences between each. 

Home Equity Loan 

  • This is paid in a lump sum up front 
  • The interest rate is fixed 
  • The best “hedge” against potential bad behavior. You total the cost of funds needed and borrow against the balance once 
  • This also comes with less flexibility 
  • Approval is contingent on other outstanding debt and your credit score 
  • You will be required to pay closing costs on the loan 
  • Commonly a bank/credit union will allow your total debt against the home to be 85% 
  • Remember, your home is the collateral. Failure to pay risks the loss of your home

Cash-Out Refinance

  • A full refinance of your home instead of a separate agreement against your current loan
  • You will be required to pay all closing costs on the loan 
  • You might not qualify for the same interest rate 
  • This option can take the longest to execute 
  • Remember, your home is the collateral. Failure to pay risks the loss of your home

When weighing each of these options it’s important to ensure you are comparing apples to apples. For example, will the closing costs outweigh the interest saved? If your interest rates increases as a result of a Cash-Out Refinance will you truly be saving over the life of the loan? Add up the fees and interest paid for each option to make sure you are truly making the best financial decision. 

Remember, if you hope to find yourself in a better position than you reside you must first make a commitment to change. It doesn’t matter if you pay 3% interest or 30% interest if you don’t have a plan to stop living beyond your means.