Q: We are having a hard time keeping up with our credit card debt, but we do have a fair amount of equity in our home. Is it a good idea to do a cash-out refinancing so we can use some of that equity to pay off our credit card debt?
A: There are a couple of good arguments in favor of your idea, but their are also some serious cautions to consider before you go ahead.
The arguments in favor:
- You'll save money on interest. According to the Federal Reserve, the average rate being charged on credit cards these days is a little more than 13 percent. Current mortgage rates are about a third of that, so you could certainly save some interest expense by exchanging your credit card debt for mortgage debt.
- It will help you avoid credit trouble. Debt often becomes a vicious cycle: People have trouble making payments, so their credit rating goes down. People with lower credit ratings have to pay higher interest rates, which makes their debt more expensive and their payments that much harder to make. Tapping into home equity may help you break this cycle.
Here are three cautions:
- A home-equity loan may beat cash-out refinancing. The choice between these products depends on how today's refinance rates compare to your existing mortgage rate. If current mortgage rates are cheaper than your existing mortgage rate, then a cash-out refinancing could be a way of killing two birds with one stone: accessing some home equity while lowering the interest rate on your existing mortgage debt. However, if you can't get a refinance rate that's better than your existing mortgage rate, why not just use a home-equity loan to borrow what you need to pay off credit card debt, while leaving the lower rate on your current mortgage intact?
- You could be setting yourself up for the same trouble again. Whether you refinance or use a home-equity loan, see what your new mortgage payments would be, given current mortgage rates and the additional debt you would be taking on. Then, see if you can create a budget around these payments that does not involve running up further debts. Otherwise, you will just be back in the same boat some time in the future, only without that home equity to bail you out next time.
- Your home may now be on the line. Defaulting on any debt is serious, but risking losing your home is especially dangerous. This is another reason careful budgeting is important before you refinance. If you are simply exchanging credit card payments you are having trouble meeting for mortgage payments you would have trouble meeting, then using home equity to pay off credit card debt is a bad idea.
In short, tapping into home equity to pay off credit card debt may make sense, provided you don't just use it as a temporary way to get out of a hole, but as part of a plan to get out of the hole and stay out.