Do you have a lot of equity in your home, but are also managing a hefty amount of credit card debt? Well, you might be wondering if it’s a good idea to take out a home equity line of credit (HELOC), and pay off those credit cards.
At first glance, this seems like a really smart financial move. Getting a HELOC allows you to borrow money at a lower 👇 interest rate, and fully pay off that higher interest 👆bad credit card debt in one fell swoop. But, the decision isn’t really that cut and dry. A lot depends on the available interest rates, your payoff timeline, credit score and transaction fees.
Basic Mechanics of a HELOC
A Home Equity Line of Credit, or HELOC, is like an open-ended line of credit that lets you borrow against the equity you’ve built up in your house. Think of it as a flexible loan with your property as collateral.
Here’s how it works: First your lender approves you for a set credit limit. This is based on your home’s value, minus what you still owe on your mortgage. You can then borrow from that line of credit whenever you need, usually over a set period called the “draw period”. During this time (typically between 5-10 years) you might only need to make interest payments on what you’ve borrowed. And then after the draw period ends, you’ll start repaying both principal and interest.
As far as interest rates, most HELOCs have a variable interest rate. This means that your rate rises and falls month to month, affected mostly by the federal fund rate.
Credit cards vs. HELOC debt
HELOCs are different from credit cards in a few key ways. First, the interest rates are typically much lower for HELOCs because they’re secured by your home (and credit cards are secured by nothing). Lower interest rates on a HELOC means significant savings compared to high rates on credit cards.
Obviously HELOCs are only available to people who own homes. Renters are not eligible. And most lenders will require at least a 80% loan to value ratio to be approved. This means the outstanding mortgage on the property cannot exceed 80% of the home’s fair market value.
Unlike personal loans or auto loans, which give you a lump sum upfront, a HELOC lets you borrow only what you need, when you need it. This flexibility is amazing, actually. You can borrow money in small chunks and pay the balance off at any time. Borrow, pay back. Borrow, pay back. In the times you don’t borrow anything, you don’t owe anything.
Potential benefits of accessing home equity
Tapping into your home equity through a HELOC can be really exciting. And it let’s you do some cool things:
You can use the money for anything: Beyond just paying off high-interest credit card debt, you could use it for home improvements, education expenses, or even as an “extra big” emergency fund to cover life’s potential disasters.
Low-ish rates: Rates on HELOCs aren’t cheap. But they’re better than credit card interest rates! The potential for lower interest rates means you could finance projects that would otherwise cost an arm and a leg via other financing methods. Plus, the interest you pay on a HELOC might be tax-deductible if you use it for home improvements (always check with a tax professional on this!).
Financial breathing room: Accessing your home equity can also ease some pent up money stress. It’s reassuring to know you have thousands of dollars at your disposal if a disaster pops up. Having more control gives you more confidence and security.
Benefits of Using a HELOC to Pay Off Credit Card Debt
If you’re feeling stuck in a cycle of credit card debt, using a HELOC to pay it off could be a game-changer for your finances. Let’s dive into some of the key benefits:
1. Lower interest rates compared to credit cards
Credit cards are notorious for their high interest rates. We’re talking like 16% to 30%+! With HELOCs, rates are typically much lower. Like in the range of 5% to 15%. This means you could potentially cut your interest rate in half or more, depending on your specific situation and what’s going on with rates in the moment.
2. Possible tax benefits (consult a tax advisor for specifics)
It’s worth noting that there might be some tax advantages to using a HELOC. In some cases, the interest you pay on a HELOC may be tax-deductible, especially if you use the funds for home improvements. For credit cards, no debt payments or interest are tax deductible.
3. Simplified payment process
Using a HELOC to pay off multiple credit cards can significantly streamline your finances. Instead of juggling several different due dates and minimum payments, you’ll have just one payment to manage each month. This simplification can make it easier to stay on top of your debt and avoid late fees.
4. Potential for debt consolidation
Consolidating multiple credit cards debts into a HELOC can provide a clearer path to becoming debt-free. Sometimes it’s just easier to make progress on paying down a single loan vs. treading water with minimum payments across different banks. It’s a psychological benefit, and one that’s proven to work!
Considerations and Risks
Before you rush out and get a HELOC, let’s review the potential risks involved. There are many. Making an informed decision means looking at the full picture!
1. The risk of using your home as collateral
One of the biggest risks of a HELOC is that it’s secured by your home. This means that if you’re unable to make your HELOC payments, you could potentially face foreclosure. While that might seem unlikely now, situations can drastically change over a few short years, especially if interest rates rise, impacting your payment amount. You’ll want to make sure you have stable and reliable income long into the future, and be confident that you can make payments on time, every time.
2. The temptation to accumulate more debt
Using a HELOC to pay off credit card debt feel like you’re getting a fresh start. But you could eventually fall into old habits and start getting into trouble with credit cards again. With $0 credit card debt and breathing room from a lower interest rate, many people abuse that freedom and start racking up new credit card debt.
It’s incredibly important to stay disciplined and focus on the end goal of complete debt freedom in life. Once your credit cards are paid off, don’t allow yourself to slip back into old habits. Focus on paying off the HELOC completely. Making and sticking to a budget will help you stay on track!
3. HELOCs often have closing costs and fees!
There are typically costs involved in setting up a HELOC. Things like application fees, appraisal fees, and closing costs aren’t cheap! So you’ll want to factor these costs into your decision making process to make sure the move is worth it.
And just like any home loan or mortgage, shop around and compare offers from different lenders to find the best deal. Credit unions often offer some of the best terms on these products.
4. Variable interest rates
Most HELOCs come with variable interest rates, which means the interest amount can change over time.
You might be thinking, “don’t worry, rates aren’t going up anytime soon”… Well, my parents thought the same thing when they had a variable home loan in the 80’s. Inflation and rates exploded in the first few years of ownership, and they ended up paying ~18% interest on their loan OUCH!
So while rates might seem low now (and definitely low compared to your credit card interest rate), know that they can increase in the future, leading to higher monthly payments. Anyone considering a HELOC should be prepared for potential rate fluctuations. If you’re averse to potential rate changes, a home equity loan might be a better fit for your situation.
5. Impact on your credit score
Taking out a HELOC will affect your credit score. The initial inquiry and new line of credit might cause a temporary dip, and it could even stay down for a while if you use a significant portion of your available HELOC. Your credit utilization ratio makes up a huge chunk of your credit score!
That being said, paying off outstanding credit card debt should improve your credit score over time. In any case, anyone taking out a HELOC to pay off credit card debt should keep an eye on their credit score, and always practice good credit card habits.
So, is a HELOC right for you?
Now that we’ve covered the potential benefits and risks, let’s run through when it makes sense to get a HELOC to pay off credit card debt. Everyone’s financial journey is unique and so much of this depends on your personal circumstances.
When it makes sense:
A HELOC to pay off credit card debt could be a great option if:
- You have significant equity in your home. Generally, you’ll need at least 20% equity *after accounting for the HELOC*.
- Your credit score is in good shape. The better your score, the more likely you are to qualify for lower interest rates.
- You have a stable income. This gives you confidence in your ability to make regular payments.
- Your credit card debt has high interest rates. If you’re paying 18% or more on your cards, a HELOC’s lower rate could save you a lot.
- You’re disciplined with your spending. This is a crucial element. You’ve got to be committed to not racking up new credit card debt after paying off the old.
- You plan to stay in your home for a while. This gives you time to pay off the HELOC without the pressure of moving.
If you meet all this criteria, using a HELOC to pay off your credit card debt will likely be a reasonable financial move, allowing you to pay less interest and eradicate debt more quickly.
When to pump the brakes
On the flip side, a HELOC might not be the best choice if:
- Your income is unstable (or you’re worried about job security). Remember, your home is on the line with a HELOC.
- You don’t have much equity in your home. If you’ve only owned your home for a short time or property values have decreased, you might not even qualify.
- You’re planning to move soon. The costs of setting up a HELOC might not be worth it if you’re not staying put.
- You don’t have a good relationship with credit cards. You’ve gotta be 100% confident that you won’t run up those credit card balances again!
- Your credit score needs work. You might not qualify for rates low enough to make the HELOC worthwhile if your score is in the dumps.
If any of the above sounds like you, hold off on getting a HELOC! Improve your finances first or figure out some other alternatives to paying off your credit card debts, like starting a side hustle to bring in more money for a period of time.
Alternative options to consider
If a HELOC doesn’t seem like the right fit, don’t worry! There are plenty of other ways to tackle credit card debt.
You could use a 0% APR balance transfer credit card instead. This involves transferring all your existing credit card debt to a new credit card with an introductory offer. Paying no interest for a while (typically 12-18 months) might allow you to crush the outstanding balances faster.
Next, you might consider a cash-out refinance. This will let you lock in a new mortgage rate and spread the cash-out balance over a new 30-year term. But, this strategy means giving up your existing mortgage, which is likely at a lower rate than new mortgages are. And refinancing is expensive! So while this is an option, it’s likely a bad one for most folks.
Another option is taking out a small personal loan, which could be enough to pay off your credit card debt. Chat with your local credit union and compare the rates!
Debt consolidation is also an opinion. If you have multiple credit cards, you might be able to consolidate everything down to a single line (the one with the cheapest interest rate). This will save you a little money on interest, and still give you the psychological benefit of just a single loan to pay.
Lastly, if you are drowning in credit card debt and don’t know where to turn, GET HELP ASAP. There are a handful of non-profit debt counseling organizations that will work wonders for you. You are not alone! And opting for alternative debt products might not be the best solution for you. The best places to seek help are the NFCC and Money Management International.
How to Get Started (If You’re Ready to Take the Plunge)
So, you’ve weighed the pros and cons and decided that a HELOC might be the right move for you. Awesome! Here’s a step-by-step overview of the process:
1. Assess your home equity
First things first, you need to know how much equity you have in your home. Equity is simply the difference between your home’s current market value and the amount you still owe on your mortgage. You can get a rough estimate of your home’s value through sites like Zillow, or asking realtors about recent sales of similar homes in your area. Getting a professional appraisal is an option, but that’ll cost a bit of money. Once you’ve got an idea of your home’s value, subtract your remaining mortgage balance from this this to get your equity.
2. Shop around for the best rates
Not all HELOCs are created equal. It’s always worth shopping around! Different lenders offer different interest rates, terms, and fees.
Start by checking with your current mortgage lender and discuss options. Then, call a few other banks, credit unions, and online lenders. Credit unions often have the most attractive offerings on the HELOC front. Look for competitive interest rates, favorable terms, and low fees. Remember, a lower interest rate can save you a lot of money over the life of the loan.
3. Prepare necessary documentation for the application process
Once you’ve chosen a lender, it’s time to gather the necessary documents and file an application. Here’s the usual stuff you’ll need:
- Proof of income, like pay stubs
- Prior year tax returns
- Credit report (Lenders will pull your credit report, but it’s good to review it yourself first to ensure there are no errors)
- Existing mortgage details/statements.
- Property information, like tax and insurance, etc.
You probably went through all this to get your original home loan. It’s a very similar process, so having these docs ready will speed up the process.
4. Submit your application, wait for approval
There might be hiccups, so be ready to work with your lender and get them what they need. Try your best to stay on top of their requests and do everything in a timely manner. Miscommunication might kill the deal.
Once all your information is submitted, the lender will review your application, check your credit, and possibly order an appraisal of your home. This process can take a few weeks, so be patient.
5. Review the terms and close the deal
If your application is approved, the lender will provide you with the full terms of the HELOC. Yay! 190 pages of paperwork to read! As boring as it is, review these carefully. Pay close attention to the interest rate, draw period, repayment terms, and any fees. The devil is in the details.
If everything looks good, you’ll move on to closing. This is where you’ll sign the final paperwork and officially open your HELOC. Be prepared for some closing costs, similar to those you encountered when you first bought your home.
Use the HELOC to pay off your credit cards!
Once your HELOC is set up, you can start using it to pay off your credit card debt. Remember, don’t get tempted to buy a new jet ski. This isn’t free money, it’s your life savings! And any debt you take out will have to be repaid in the years to come. Don’t let this new source of funds derail you from your debt payoff plan.
The end goal is to completely get yourself out of debt, not to create new financial challenges. So monitor your spending, make your payments on time, and keep an eye on your overall financial health.
The Bottom Line:
Getting a HELOC to pay off credit card debt can be a proactive step towards financial stability. By leveraging the equity in your home, you could potentially cut your consumer debt interest rate in half, simplify your payments, and set yourself on a clearer path to becoming debt-free!
But, be completely honest with yourself and your motives. If there’s a chance you could fall back into a bad debt hole, reconsider your options. There are alternatives to getting a HELOC that come with far less risk. Whatever you decide, remember it’s not just about paying off debt… You’ve got the knowledge and the tools to make a positive change in your finances. Now, it’s up to you to take that next step. Cheers to a brighter, debt-free future!
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