Today I have a guest post from Tim Chen, founder and CEO of NerdWallet.com, a website that helps consumers to compare credit card reward programs. Tim also educates consumers about credit cards and debt management at the Forbes Moneybuilder Blog, the Huffington Post, and the U.S.News.
HELOC – the solution for paying off high interest credit cards?
Many of us are facing mounting credit card debt, and we’re desperate for ways to get rid of it and stop paying high interest rates. If you are a homeowner, then one option available to you is using a HELOC, or home equity line of credit, to pay off your high interest credit cards.
When deciding on whether or not to get a HELOC, you should start by determining how much you’ll actually be able to borrow. The formula used to determine your equity is really easy – it’s just the appraised value of your home, minus the mortgage amount. For example, if your home is worth $300,000 and your mortgage is $200,000 then you have $100,000 of equity in your home. Of the $100,000 you will be able to borrow a certain percentage, depending upon the bank’s lending practices. Some lenders could give you as much as 75%.
How much can you save?
A home equity line of credit allows you to use your available credit as a revolving line, much like a credit card, except that a HELOC is backed by an asset (your home) and will generally carry a lower interest rate. So why not use a HELOC to replace your credit card debt?
On paper this looks like a really good idea, because many of us are now paying interest rates of 15% or more on our credit card debt, while a home equity line of credit can have an interest rate under 6%, depending on your credit score. This is significantly lower than even most low APR credit cards and can mean big savings for you and your pocket book.
Let’s just say you owe $15,000 to a couple of credit card companies, accruing interest at 15%, and you decide to get a HELOC to pay it down with an interest rate closer to 6%. Assuming you don’t incur any more debt, this should save you thousands of dollars over the next few years, including more than $1,400 in the first year.
Another upside of getting a home equity line of credit is that it is often tax deductible. If your home debt totals less than $1 million, you can use up to $100,000 of HELOC for any purpose, while maintaining your tax deductible status. This means that after taking the deduction into consideration a HELOC with a 6% interest rate turns out to be 4.5% or less, depending on your income.
That said, HELOCs are harder to get these days, due to the fact that lenders are tightening up their criteria after the housing market crash. Plus appraisers are getting much stricter with their property valuations, which could reduce your available equity. The obstacle course you’ll have to navigate to close the loan will be longer and harder than a few years ago, but if you’re facing enough debt it may be worth it.
But how much will it cost?
For a minute let’s assume your credit is great and you’re a prime candidate for getting a home equity line of credit. That doesn’t necessarily mean it’s the right thing to do; it’s important to know all the ins and outs of a HELOC before making a decision.
While the interest rates are lower, there are often one-time fees attached to the HELOC, which can really mount up. These costs can include appraisal costs, an application fee, and closing costs, as well as “points” which may be as much 1% of the amount of the credit line. It usually pays to shop around on sites like BankRate or LendingTree to find the bank offering the best terms. You’ll then have to do some back of the envelope math, because a HELOC that costs $2,000 in upfront fees is only worth it if it will save you more than $2,000 in interest.
You also have to keep in mind that a home equity line of credit reduces your available equity and puts your home at greater risk in the event of disaster (like bankruptcy). If you eventually find yourself unable to pay, a bank can repossess your home, while a credit card company can’t. Because of this, a credit card company may also be more likely to work with you on creating an emergency payment plan.
Will it really fix the problem?
Even if you find a way to save money on your interest, you are still responsible for paying off your debts, and freeing up your credit card limits may not be the best way to force yourself to rein in your spending. You may be better off considering something like a balance transfer credit card, so that you can still mentally account for the credit card debt and focus on paying it off without adding to it.
Based on our calculations, there are card offers right now that can get you as low as a 3% APR over a two year period if you have good credit, which is a substantial difference from the 12-20% APRs offered on many rewards credit cards. So you may be able to save yourself the expense and hassle of a HELOC, while still saving money and keeping your spending in check.
Thank you, Tim!
Have you ever gotten a HELOC loan? Had you ever heard of one? Would you consider one now or in the future?