If your home is worth a lot more than you owe on it, all that equity you've earned can seem like a big pot of cash just waiting for you to tap into -- especially if you have a lot of high-interest (read: credit card) debt. But if you're thinking about taking a loan on your home in order to pay back creditors, you need to carefully weigh the pros and cons of this decision.
There are definitely some upsides to using a home equity loan or home equity line of credit to knock that high-interest debt balance down to zero, but consider these advantages and disadvantages before you start calling up mortgage lenders.
Pro: You can lower your interest rate -- a lot
The interest rate on a credit card is generally around 16% for a typical travel rewards card. By comparison, a home equity loan would likely have an interest rate around 5.2%, while a home equity loan rate is around 5.4%. This is a big drop in interest, especially when factoring in the fact that the interest you pay on your home equity loan or HELOC is tax-deductible if you itemize your deductions and if your loan was for less than $100,000.
Most home equity loans have a payback period of around five to 15 years. If you're in the 25% tax bracket and you borrow $15,000 through a home equity loan or HELOC paid back over 15 years, then you'll pay around $6,500 to $7,000 in interest (the HELOC being the more costly option). By comparison, if you have a $15,000 credit card debt at 16% and take 15 years to pay it off, you'll pay more than $24,000 in interest.
One caveat to be careful of: Your interest savings depend upon how long you take to pay off the debt. If you could pay off your credit card in one year, you'd pay less in interest even at the higher rate than you would if you stretched out your home equity loan payments over 15 years. If you can pay off your credit card debt quickly, you should do that instead of tapping into your home's equity.
Con: You could make moving impossible
When you tap into your home equity, you are taking a big risk to get a lower interest rate on your debt. One risk is that you'll end up underwater on your home -- which means you'll owe more than it is worth.
Generally, you won't be approved for a HELOC or home equity loan unless the total amount you'll owe on your home (with your first mortgage included) is less than 75%-85% of the home's value (depending upon which loan product you choose).
Still, the less equity you have, the more vulnerable you are to falling home prices. If home value drops and you end up owing more than you can sell your house for when you combine your primary mortgage and home equity loan, you'll be in a big mess if you need to move. You'll have to come with cash to the table to pay back your lenders -- and if you don't have the cash, you may be trapped in your house until home values recover or until you've paid down your mortgages.
Con: You may get hit with fees to tap into home equity
Closing costs for a home equity loan generally total around 2%-5% of the value of the loan. You may also pay points to lower your home equity loan interest rate, and some home equity loans have a maintenance fee.
HELOC fees could include an origination fee, a document preparation fee, a professional appraisal, and annual maintenance fees. Some HELOCs charge you for inactivity or for each transaction you undertake. Some will also charge a pre-payment penalty if you pay off the loan and close the account earlier than planned.
Be certain you know all up-front costs and factor in those fees when deciding whether it would be cheaper to tap into home equity to pay off debt.
Con: You're putting your home at risk of foreclosure
The biggest downside to tapping into your home's equity to pay off other debts is that you're putting your home at risk. If you cannot make the payments, your lender could foreclose, and there is a very real chance you'll lose your house.
When you owe money to a credit card company, there's very little chance your creditor will come after your property. Credit card companies do have ways of trying to collect, including suing you and getting a judgement against you -- which could lead to a lien being placed on your property. But there are a number of factors that make it almost inconceivable that you'd be forced out of your home due to unpaid credit card debt, including homestead protections that keep your house safe in many states.
Meanwhile, because a home equity loan or home equity line of credit is secured debt, and your house serves as the guarantee that you'll pay, home equity lenders can foreclose and take your home through a relatively simple process.
While you may believe you'd never fall behind on mortgage payments, lots of unexpected things can happen in life. The more equity you have in your home, the more protected you are from potentially losing it in the event of a financial disaster. Think very carefully about whether it's worth putting your home at risk to save on interest. For many people, the trade-off is just not worth it, and you're better off looking for other solutions to deal with your debt.
The Motley Fool has a disclosure policy.