If you have been subjected to huge credit card rate increases since the passage of the CARD Act, your monthly payments may have become flat-out unmanageable. Taking out a home equity loan to pay the cards off and escape the "tender mercies" of MasterCard, VISA and AmEx may have enormous appeal.
Some financial writers paint a very rosy picture of credit card debt consolidation: lower interest rates, possible tax deductions, reduced payments--what's not to like? Then there are the other articles such as Dave Ramsey's "The Truth About Debt Consolidation." He writes, "Debt consolidation is nothing more than a 'con' because you think you've done something about the debt problem. The debt is still there, as are the habits that caused it - you just moved it!"
Home Equity Loans and Debt Consolidation Failure
The truth lies somewhere between those extremes. Debt consolidation done poorly has a very high failure rate -- about 80%, according to experts. Failed debt consolidation means that not only do you still have the debt monkey on your back, but you have drained the equity out of your property and increased your overall payments to boot. And there's more. Because you're using your home as collateral, debt consolidation through a home equity loan can increase your chances of losing your home.
Why Home Equity Debt Consolidations Fail
Those selling the home equity loans for debt consolidation don't usually mislead their customers. The payments are, in fact, lower. The home equity loans, being secured by real property, generally do carry better interest rates than unsecured consumer debt. And yet, debt consolidation fails over and over because of several misconceptions. Here are the truths:
1. Your debt does not go away. Your debt isn't really paid off with a debt consolidation mortgage; you just exchange unsecured obligations (credit card debt) for a secured loan (home equity loan). You still have the same amount of debt -- it just grows more slowly than it otherwise would. It's amazing how many people forget this simple fact: Your debt won't go away until you pay it off. You've turned unsecured debt into secured debt. That change can have benefits, but many of them accrue to the lender, not you.
2. Your payment is lower because your short-term debt is now a 30-year loan. Try this with HSH.com's mortgage amortization calculator. Take one of your credit card balances and input it as a 30-year mortgage with the same credit card interest rate that you're paying now. Your payment probably drops significantly, doesn't it? And yet you know that you aren't saving any money since the interest rate has not decreased. The calculator also displays the total amount of interest paid over the loan's lifetime.
3. Debt consolidation does not resolve your over-spending issues. If you got into trouble because you couldn't control your spending, wiping your balances out won't teach you restraint. Debt consolidation without budgeting advice and credit counseling may be the only way to get you financially healthy for good. However, if not done properly, "Debt consolidation can be a shiny new shovel to dig yourself deeper into debt," said HSH VP Keith Gumbinger.
Debt Consolidation the Right Way
Debt consolidation can in fact lower your payments and save you a great deal of money. Current mortgage interest rates -- home equity rates -- are between 7% and 8% as of March 2010. This is a fraction of what many credit card holders are paying in interest, and then there are the potential tax savings (consult a finance professional to understand the tax deductibility options).
To successfully consolidate your debt with a home equity loan, do these three things:
1. See a credit counselor. Find a reputable credit counselor, one who charges reasonable fees and doesn't try to sell you a product or a plan. Your sessions should focus on learning to budget, paying bills on time and saying "no" when you can't afford something you want.
2. Get rid of the problem. Close out your credit card accounts. Be sure to call the card companies and have them report the accounts as "closed by cardholder" to the credit bureaus (or you can send a credit card cancellation letter). When they send you new cards (and they almost always try this), shred them and call to confirm that your account remains closed. Switch to a debit card so you can better control your spending.
3. Accelerate your payoff. Your debt consolidation loan payment will be lower than the total of all your credit card payments (or you wouldn't have taken the loan, right?). But you're not done. Decide, with the help of your credit counselor if necessary, how much extra you can afford to pay toward retiring that balance. Input that as an extra principal payment in the mortgage amortization calculator, and it should tell you how long it will take to pay off the debt completely and how much interest you will pay over the life of the loan.
This helps you plan for financial health. Once you have eliminated your consumer debt, take what you are no longer paying each month and put it into your savings account. You can be part of the 20% who use home equity loans to successfully conquer consumer debt!
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.
