Ready to Consolidate That Debt?

Updated on November 22, 2006.

IF YOU'RE A homeowner saddled with debt (and we're talking about high-interest debt like the kind you pile up on credit cards), then a home-equity line of credit, or HELOC, might be a good escape hatch. After all, the average credit card now carries an annual percentage rate (APR) of around 14%, whereas the average APR for a $30,000 HELOC is about 8.2%, according to Bankrate.com. And that's before you consider the tax break on your interest payments.

From a pure number-crunching perspective, consolidating high-interest, nondeductible debt into a HELOC or a home-equity loan, or HEL, is a no-brainer. Of course, your home is the collateral for such a loan, and foreclosure could leave you bunking down in Mom's den. So look in the mirror. If you're the type who will simply accumulate more debt once you've wiped the slate clean on your credit cards, forget the loan and pay a visit to our Debt Management Center, where we encourage you to read our article "Help! I'm Drowning in Debt."

Assuming you can resist temptation, however (or if your debt was accrued because of a one-time expense like a divorce or unexpected medical bills), rolling over your debt can save you loads of money. As you probably know, part of the beauty of a home-equity loan is that up to $100,000 of interest ($50,000 if you're married but filing separately) is tax deductible. That's assuming your loan doesn't exceed the value of your home (so stay away from those sleazy no-equity loans).

Consider this: If you had $10,000 worth of credit-card debt at 14% and paid it off at $250 a month, it would take you four and a half years and $3,590 in interest to kiss it goodbye. But with that 8.2% rate, you'd pay about $1,319 in interest (again, before the tax deduction) and could pay off your loan in slightly less than four years.

Have we convinced you yet? Well, before you ante up the homestead, there's a fair amount you need to consider. So here's a quick tutorial.

Debt Swap Strategies
These days, about 35% of the HELs and 45% of HELOCs taken out are used to refinance debt, according to a recent study by the Consumer Bankers Association, making it easily the No. 1 reason for taking out these loans.

But just because you're paying steep interest on your credit-card balance doesn't necessarily mean you should take out a HELOC. If you have less than $10,000 worth of debt (and the average household with at least one credit card carries about $9,159 in credit-card debt, according to CardWeb.com), a smarter strategy may be to simply find a better way to budget yourself while also transferring your debt to a credit card with a lower interest rate.

This is in part because you often have to borrow at least $10,000 to take out one of these loans. But it's also because you just might be climbing along a slippery slope. People who take out home loans for small amounts start to look at the excess loan amount as a tool for paying for other things, says Certified Financial Planner Scott Kahan, president of Financial Asset Management. Once the credit line is open, "suddenly they'll run up another $5,000 of debt here, they'll go on vacation — all of a sudden they've pulled out $20,000 or $30,000."

The Three Options
So far we've mentioned two types of home-equity products: home-equity loans and home-equity lines of credit. There's also a third option, known as cash-out refinancing. Each of these can be used for debt consolidation, and each has its pros and cons. Here's a quick review.

These days, the preferred loan is the home-equity line of credit, which works pretty much like a credit card. You're given a maximum loan amount of, say, $20,000, which you can then run up or pay off as you choose. Lines of credit are directly tied to the prime rate. Typically you'll pay the prime rate plus a small markup. (Introductory rates may be lower than that.) Usually there are minimal or no up-front costs to take out a HELOC, and the flexibility of these loans makes them ideal for irregular expenses, like those that inevitably come up during a remodeling project. It also makes them potentially risky for those who can't have a line of credit open without maxing it.

A home-equity loan, by contrast, works a lot like a mini fixed-rate mortgage. You get a lump sum, which you are then expected to pay back via regular monthly payments over a set amount of time. Rather than moving with the prime rate, these loans tend to track short- and midterm deposit costs, explains Keith Gumbinger, vice president of HSH Associates, a mortgage-tracking firm. The current average home-equity-loan rate is 8.0% on a $30,000 loan, according to Bankrate.com. Typically you'll pay fees and costs of somewhere between $200 to $1,000 to take out a HEL, says Gumbinger.

A HEL can be handy for debt consolidation, since you know exactly how much you owe on your credit cards, and if you take out exactly that amount, you don't run the risk of piling on more debt. Clearly, though, you're not going to be doing yourself any favors if you spread out your debt over the next decade, thus ensuring that those Jimmy Choo shoes will eventually wind up costing you the equivalent of a year's worth of college.

Finally, there's the cash-out mortgage refinance. As the name implies, with this type of loan you refinance your mortgage, taking out an extra bit for yourself. (Right now the average rate for a 30-year fixed-rate mortgage is 6.2%, according to Bankrate.com.) This can be a great move, but since refinancing comes with its own costs, it's worth considering only if you were already planning on refinancing anyway. Also, if you do decide to go this route, make sure you can pay ahead of schedule without getting smacked with a penalty.