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Think long and hard before borrowing against your home
A growing number of Americans are finding themselves with far more debt on their charge cards than they can handle. Taking out a low-interest home equity loan to consolidate high-interest credit card bills may seem like a good idea. But many borrowers are courting trouble. At first glance, the simplicity of consolidating debt from different cards with various due dates to one lender at a lower interest rate may be appealing. An added benefit is the tax write-off on the loan's interest. But borrowing against your home to pay off debt stretches lower monthly payments over a longer period of time, masking years of compounded interest. Of course, the more you owe and the longer you take to pay off the total amount, the more your loan will cost in the end. "You don't want to have that dinner you charged six months ago be on your home equity loan for the next 10 years," says Joanne Kerstetter, president of Consumer Credit Counseling Service of Greater Washington, D.C. "That would be a very expensive meal." Home equity loans are commonly used to generate cash for remodeling a house or sending a child to college; they also are an option for homeowners who have been accumulating debt at a rapid pace. The upward trajectory in consumer debt has been steep. According to the Federal Reserve, consumer debt rose to $1.653 trillion in the third quarter of 2001, up $19.9 billion from the second quarter. In 1996, consumer debt was $1.185 trillion, almost half a trillion dollars below where it is today.
Lower monthly payments offered by a home equity loan may make your debt look more manageable. But over the long run, you will likely pay more -- even after you deduct the amount you save via tax write-offs on interest payments. Let's say you have $20,000 worth of credit card bills at 15%. A monthly payment of $1,000 would pay off the balance in two years, with $3,273.59 in interest paid on the principal. With a 10-year home equity loan at a 7.5% interest rate, the monthly payments on $20,000 would drop to $237.40, but the interest paid over time would be $8,488.42 -- more than $5,000 more. In addition to the payments on compounded interest, home equity loans put at risk what is probably your most valuable asset. Credit card companies can't take your house if you don't pay their bills, but it is collateral for a home equity loan. "You put your house in jeopardy if you fall behind on payments," Kerstetter says. Indeed, mortgage foreclosures and delinquencies are increasing, according to the Mortgage Bankers Association of America. In the third quarter, the mortgage delinquency rate rose to 4.87%, up 24 basis points from the second quarter, while the percentage of loans in foreclosure rose to 0.38% in the third quarter, up 2 basis points from the previous quarter. "A home equity loan is an equity-destroying loan," says Randy Johnson, a mortgage broker and author of How to Save Thousands of Dollars on Your Home Mortgage. People eating into the equity of their homes rarely reach the typical goal of refinancing: to get out of debt and pay off principal, Johnson says.
After consolidating payments and reaching a zero balance on their credit cards, many people are fooled into thinking they're in the clear, and they resume their old spending habits. As a result, refinancing becomes "a short-term cure for your inability to control your appetite," Johnson says. He offers an example of a client who wanted to eliminate a $375,000 debt, only to owe $625,000 in two home equity loans later because of uncontrolled spending. But home equity loans could be a good idea for those who have a smaller amount of credit card debt. A $2,000 card debt refinanced with a home equity loan at 6% over 10 years is easier to pay off, with a monthly payment of $22.20 and a total cost of $2,664. Paying $50 more a month would pay the debt off in two and a half years with a total cost of $2,158. Debtors searching for a lower rate instead of a lower monthly payment also should consider a home equity loan, says Malcolm Makim, certified financial planner and president of Professional Planning Group of Westerly, R.I. By continuing to pay the same amount they pay on their high-interest credit card bills at the low home equity rate, debtors can pay off the principal more quickly. However, Makim warns that this requires financial discipline that many in debt don't have. "There is a need for people who run into this situation to do what alcoholics do. Take a clear, sober look at spending habits and determine if use of credit is a problem," he says, "You should not get a home equity loan without having a clear game plan for paying it off."