If you're a homeowner saddled with debt (and we're talking about bad, high-interest debt like the kind you pile up on credit cards) then Alan Greenspan has offered you an escape route. How so? Well, while credit-card interest rates have become increasingly immune to Fed rate cuts (with the average fixed-rate credit card now charging 13.5%), home-equity lines of credit, or HELOCs, have fallen below 4.0%. That's one of the lowest rates we've seen since these products first became popular back in the mid-1980s. And better yet, that rate is before you consider the tax break on your interest payments.
Indeed, from a pure number-crunching perspective, consolidating high-interest, nondeductible debt into a HELOC or a home-equity loan, or HEL, is a no-brainer. Of course, your home is the collateral for such a loan, and foreclosure could leave you bunking down in Mom's den. So look in the mirror. If you're the type who will simply accumulate more debt once you're wiped the slate clean on your credit cards, forget the loan and pay a visit to our Debt Management Center, where we encourage you to read our article "Help! I'm Drowning in Debt."
Assuming you can resist temptation, however (or if your debt was accrued because of a one-time expense like a car, boat or unexpected medical bills), rolling over your debt can save you loads of money. As you probably know, part of the beauty of a home-equity loan is that up to $100,000 of interest ($50,000 if you're married but filing separately) is tax deductible. That's assuming your loan doesn't exceed the value of your home (so stay away from those sleazy no-equity loans). If, say, you're in the 28% tax bracket, the after-tax equivalent of a HELOC financed at 3.6% would be a mere 2.59%.
And consider this: If you had $10,000 worth of credit-card debt at 16% and paid it off at $250 a month, it would take you nearly five years and $4,400 in interest to kiss it goodbye. But with that 2.59% rate, you'd pay about $469 in interest (keep in mind, this is after the tax deduction) and could pay off your loan in roughly three-and-a-half years.
Have we convinced you yet? Well, before you ante up the homestead, there's a fair amount you need to consider. So here's a quick tutorial.
Debt Swap Strategies
These days, about 40% of the HELs and HELOCs taken out are used for debt consolidation, according to a recent study by the Consumer Bankers Association, making it easily the No. 1 reason for taking out these loans. The runner-up is home improvement, and certainly, in this environment, taking out a loan for this reason can make sense, too.
But just because your credit card is a bad bargain (and, hello, all credit cards are rotten deals once you decide to carry a balance) doesn't necessarily mean you should take out a HELOC. If you have less than $10,000 worth of debt (and the average household with at least one credit card carries about $8,000 in credit card debt), a smarter strategy is to simply find a better way to budget yourself while also transferring your debt to a credit-card with a lower interest rate.
This is in part because you often have to borrow at least $10,000 to take out one of these loans, or at the very least to qualify for the best rates. But it's also because you just might find a slippery slope. People who take out home loans for small amounts start to look at their homes as a treasure chest to pay for other things, says Certified Financial Planner Scott Kahan, president of Financial Asset Management. Once the credit line is open, "suddenly they'll run up another $5,000 of debt here, they'll go on vacation — all of a sudden they've pulled out $20,000 or $30,000." Kahan says that using a home-equity loan for debt consolidation makes the most sense if you have serious credit-card debt, or perhaps credit-card debt combined with other debt, like a car loan or expenses incurred for remodeling your home.
The Three Options
So far we've mentioned two types of home-equity products: Home-equity loans and home-equity lines of credit. There's also a third option, known as cash-out refinancing. Each of these can be used for debt consolidation, and each has its pros and cons. Here's a quick review.
These days, the hot loan is the home-equity line of credit, which works pretty much like a credit card. You're given a maximum loan amount of, say, $20,000, which you can then run up or pay off as you choose. Since lines of credit are directly tied to the prime rate, these are currently the cheapest loans in the home-equity market. This won't always be the case, however. For as dark as the clouds overhead may seem today, the economic picture will improve, and these rates will head north when the time comes for Greenspan to tighten things up. For now, though, given today's competitive market, you can find HELOCs at the prime rate plus a small markup and teaser rates for a point or even more below prime. Usually there are minimal or no up-front costs to take out a HELOC, and the flexibility of these loans makes them ideal for irregular expenses, like those that inevitably come up during a remodeling project. It also makes them potentially risky for those who can't have a line of credit open without maxing it.
A home-equity loan, by contrast, works a lot like a mini fixed-rate mortgage. You get a lump sum, which you are then expected to pay back via regular monthly payments over a set amount of time. Rather than moving with the prime rate, these loans tend to track short- and mid-term deposit costs, explains Keith Gumbinger, Vice President of HSH Associates, a mortgage tracking firm. These rates have been declining, though not as much as the prime rate. Even so, the current average home-equity-loan rate of 6.84% on $10,000 (according to Bankrate.com) is fantastic for a fixed-rate loan. Typically you'll pay fees and costs of somewhere between $200 to $1,000 to take out a HEL, says Gumbinger.
A HEL can be handy for debt consolidation, since you know exactly how much you owe on your credit cards, and if you take out exactly that amount, you don't run the risk of piling on more debt. Clearly, though, you're not going to be doing yourself any favors if you spread out your debt over the next decade, thus ensuring that those Jimmy Choo shoes will eventually wind up costing you the equivalent of a year's worth of college.
Finally, there's the cash-out mortgage refinance. As the name implies, with this type of loan you refinance your mortgage, taking out an extra bit for yourself. (Right now the average rate for a 30-year fixed-rate mortgage is 5.24%, according to Bankrate.com.) This can be a great move, but since refinancing comes with its own costs, it's worth considering only if you were already planning on refinancing anyway. Also, if you do decide to go this route, make sure you can pay ahead of schedule without getting smacked with a penalty. After all, if you think financing Jimmy Choo shoes over 30 years is a reasonable thing to do, you should probably get in touch with a therapist in addition to a financial planner.
So how do you find the best rates? Thorough research, of course. Start with your local paper, but the old adage "what the big print giveth, the small print taketh away" certainly applies here, warns Joe Kennedy, president of E-Loan. Often the best rates are teasers or apply only to high balances. They also often don't include fees, like annual charges, or early termination fees, which come with many HELOCs. Also, keep in mind the rates quoted in newspapers are notoriously low-balled, so don't be surprised if you find that the rates that you get over the phone are slightly higher.
Be sure to check both the big lenders and the little ones, advises Gumbinger. You'll often find that the best rates are offered by local banks, savings and loans and credit unions. Of course, as with any type of loan, the best rates are going to be doled out to the best customers. So to qualify for that 3.6% HELOC that some lenders are bandying about these days, you need to have flawless credit plus a combined loan-to-value ratio that's below 80% (meaning, your first and second mortgage can't equal more than 80% of your home's value), says Kennedy. But you probably wouldn't want to do that anyway. After all, it's one thing to max out your credit cards, and quite another to turn your home into a house of cards.