Suppose you're carrying $5,000 to $10,000 in debt and someone offers you the choice of paying 6.5 percent interest or 20 percent interest on that amount? Wouldn't you jump to take advantage of the lower rate?
Homeowners who have built up some equity in their homes may have that option. Using a home equity loan (borrowing a fixed amount of money) or a home equity line of credit (borrowing what you want up to a certain amount) to pay off credit card debt has become a popular debt reduction strategy.
It's easy to see why homeowners may consider this approach. Suppose you owe $5,000 in credit card debt and are paying paid $300 a month towards reducing it. If you're paying 18 percent interest, you'll be able to pay that loan back in 20 months and your total interest paid will amount to $797. If you're paying 24.9 percent interest--the top rate charged by some credit card companies--it will take you 21 payments to eliminate the debt and you'll end shelling out $1200 in interest.
Now contrast that with paying off the $5,000 with a home equity loan, which are currently running at about 6.5 percent interest. Not only would you pay off the debt faster--it would take just 18 months to eliminate it--but you'd also pay only $255 in interest. That's almost a $1,000 savings over the interest you'd pay with a 24.9 percent rate!
If you're suffering from credit card debt, it may be tempting to go out and apply for a home equity loan immediately. However, you need to ask yourself a few questions before you proceed.
One advantage to using a home equity loan to pay off your credit card debt is the money you'll save on interest. You'll also be able to get out of debt sooner, which could help improve your credit rating.
There's also a greater predictability with a home equity loan; you know up front how much you're going to need to pay each month and how soon you can expect to be debt free. (With credit card payments you need discipline to make monthly payments; it's all too easy to decide that you'll reduce your payment for "just this month.")
But there are some disadvantages to this debt reduction strategy as well. For one thing, you're putting your house at risk--if you're not able to make payments because of an illness or job loss, you run the risk of the bank taking over your house. You don't face that when you're delinquent with credit card bills.
It's also easy for you to slip back into old spending habits and overspend on your credit cards, leaving you more in debt than ever. You could end up with a home equity loan to pay off in addition to your credit card debt.
In addition, you may have to pay some fees for setting up or maintaining a line of credit, which could reduce the amount of money you save overall.
The Federal Reserve Board offers an informative booklet on home equity lines of credit. Before you make any decision about paying off your credit card debt with a home equity loan, be sure you understand how they work and just what you'll be risking if you use one.