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If you're a homeowner saddled with debt (and we're talking about high-interest debt like the kind you pile up on credit cards), then a home equity line of credit, or HELOC, might be a good escape hatch. After all, the average credit card now carries an annual percentage rate (APR) of around 14%, whereas the average APR for a $30,000 HELOC is about 8.2%, according to Bankrate.com
. And that's before you consider the tax break on your interest payments.
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.
Assuming you won't simply accumulate more debt once you've wiped the slate clean on your credit cards, however (or if your debt was accrued because of a one-time expense like a divorce 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 in most cases homeowners can write off the interest on a loan up to $100,000.
Consider this: If you had $10,000 worth of credit-card debt at 14% and paid it off at $250 a month, it would take you 4½ years and $3,590 in interest to kiss it goodbye. But with that 8.2% rate, you'd pay about $1,319 in interest (again, before the tax deduction) and could pay off your loan in slightly less than 4 years. These days, about 35% of the HELs and 45% of HELOCs taken out are used to refinance debt, according to a recent study by the Consumer Bankers Association, making it easily the No. 1 reason for taking out these loans.
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.
The Three Options
So far we've mentioned 2 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 preferred 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. Lines of credit are directly tied to the prime rate. Typically you'll pay the prime rate plus a small markup. (Introductory rates may be lower than that.) 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 does, however, make 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 midterm deposit costs, explains Keith Gumbinger, vice president of HSH Associates, a mortgage-tracking firm. The current average home equity loan rate is 8.0% on a $30,000 loan, according to Bankrate.com. 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.
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 6.2%, 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 a penalty.