Debt consolidation loans can be a good option for paying off credit card debt. Borrowers can make one lower payment to a lender by consolidating their bills instead of many payments to different credit card companies.
But because they're non-secured loans that don't require collateral, debt consolidation loan rates can be twice as high as secured loans such as home equity loans, where homeowners put their home up as collateral if they don't make the payments.
For many people, getting a secured loan through a home equity loan to pay off debts is the best way to pay off credit card debt. Paying off debts is one of the most common reasons why homeowners either refinance their home loans or take out home equity loans, says Rich Leffler, director of mortgage origination training at AxSellerated Development near Baltimore.
Dealing with debt is an area where more Americans need help. Outstanding consumer debt in the U.S. was at $3.24 trillion in August, according to the Federal Reserve, while outstanding revolving debt was at $880.3 billion.
The Tax Reform Act of 1986 eliminated the tax deductibility of credit card interest, while retaining the tax deduction on interest paid on mortgage loans. "That sent the housing industry into a frenzy," Leffler says.
Homeowners could refinance a mortgage and add some extra money to the loan to pay off debts without increasing their monthly payments by much, or they could take out a home equity loan. Mortgage interest is deductible on federal taxes for most people. Interest paid on credit card debt isn't tax deductible.
The major catch of a home equity loan, however, was losing the home if the borrower defaults on the loan. "You're putting your home on the line," Leffler says.
With that caveat in mind, there are still times when a home equity loan can be a good way to pay off credit card and other debts. Here are some of the pros and cons of such loans:
Don't expect to take out too much equity
The days of tapping up to 125 percent of your home equity and spending it on a new car or vacation are over. Lenders are more conservative now than they were during the housing crisis, and taking out 20 percent equity is more common now, Leffler says.
Low loan rates
One of the most enticing things about a home equity loan is that it's set for the length of the mortgage, usually 20 to 30 years. Mortgage rates are at all-time lows, so locking in a loan for 30 years and taking out some of the money to pay credit card debts can result in a lower monthly payments than a credit card bill would.
Another type of loan, a home equity line of credit, also called a HELOC, has an interest rate that's a little lower than a home equity loan. The money can be drawn during 10 years, and borrowers then have 15 years to repay the loan.
Other types of debt consolidation loans have higher interest rates than home equity loans because they're unsecured and the lender takes on a bigger risk of the borrower not making payments, says Thomas Nitzsche, a certified credit counselor and media relations manager for ClearPoint Credit Counseling Solutions, a debt counseling service based in Atlanta.
"If you come upon a financial hardship, that's going to be one of the first things to go by the wayside is an unsecured debt consolidation loan," Nitzsche says.
First, do the math
But don't let long loan repayment periods deceive you into thinking you're paying less, even with a low interest rate, says Casey Fleming, a mortgage adviser in San Jose, Calif., and author of "The Loan Guide: How to Get the Best Possible Mortgage."
"Usually if people use debt consolidation loans with home equity loans, in the long run they will spend more on interest than if they hadn't," Fleming says.
That's because the lower monthly payment will be made over decades instead of a few years. He offers the example of a $30,000 debt paid with various methods.
A credit card with a 15 percent interest rate will require a minimum payment of $900 per month and will take 43 months, or 3.6 years, to pay off and will result in $9,060 in interest paid.
A home equity line at 4.25 percent interest with the minimum payment of $106 during the first 10 years and $225 in the last 15 years will take 25 years to pay off with $23,373 in interest paid - or 2.5 times the interest paid on the revolving credit loan.
That's why Fleming recommends to clients considering home equity loans for debt consolidation to pay off the home equity loan as fast as they would the minimum payment on their credit card bill. In the example above, that's 43 months.
Paying off that same home equity loan in 43 months would require a minimum monthly payment of $746, resulting in $2,417 in interest paid. The payment is about $150 less per month than it would be with the credit card payment, and pays the $30,000 debt off in the same amount of time but at $6,643 less in total interest paid.
If a home equity loan is repaid during the length of the loan - meaning lower monthly payments - then the homeowner would pay more money overall for a loan that looks inexpensive. It's the same reason why cars and phone payments are spread out over years - to make the monthly cost palatable while the overall cost is high.
"This is the same thing we do when we buy a car," says Nitzsche, the credit counselor. "We look at the monthly payment. We don't look at the cost over time."
ClearPoint discourages people from using longer repayment periods, he says. They can lead to a pattern of continued spending, which can lead to more debt, he says.
Lose bankruptcy option
People in credit card debt should keep all of their options open, and unsecured credit card debt can be removed through bankruptcy, Fleming says.
"Once you convert unsecured debt to secured debt, you can't get rid of it in bankruptcy anymore," he says.
"At the end of the day, if you're in trouble," Fleming says, "it would seem to me that losing your home would be the worst choice."