HELOC vs. cash-out refinance for card debt repayment
On paper, it may look as if it makes a lot of sense to replace high interest card debt with a low interest payment if you have home equity you can tap into. If it's available and will ease your pay-off pain, why not use it, right?
While using a home equity line of credit (HELOC) or cash-out refinance (in which you refinance your mortgage, but tack on an additional cash payout) to rectify your debt woes might seem like a no-brainer, there are lots of factors to consider to determine which avenue is right for you or if you should go that route at all.
"One size doesn't fit all," says Malcolm Hollensteiner, director of retail lending sales at TD Bank. "Utilizing equity to pay down or eliminate higher interest rate consumer debt can be a very beneficial strategy, but it should be done in moderation, accessing some -- not all -- of your equity," he says.
Gone are the days when banks allowed homeowners to tap into 125 percent of their home value (thanks to the lessons learned during the real estate market meltdown, which left many people "underwater," owing more on their home loans than the value of the home). And, you'll need to have a respectable credit score to qualify. But even with more restrictions in place now than in years past, borrowers still should tread carefully if they're contemplating borrowing against their home.
"Although the interest rates are much lower on a HELOC or cash-out, the issue becomes that you're taking your short-term debt and turning it into something you're going to be paying back for 30 years," says John Walsh, CEO of Total Mortgage Services.
And then there's the risk factor. Before you jump on that lower rate, you have to understand that if you cannot keep up with your new payments, you risk going into foreclosure, warns David Reiss, professor of law and research director of the Center for Urban Business Entrepreneurship at Brooklyn Law School, who also writes the REFinBlog. "In other words, you are getting the lower rate in exchange for putting up your house as collateral for the debt," he says.
With stakes this high, it's not as simple as using a HELOC or cash-out refinance as your "get out of debt free" card. Here are the factors you need to consider.
Home equity line of credit
A HELOC is a variable interest rate product that allows consumers to access the available equity in their home. The attractive feature is that it's a line of credit, meaning you can borrow whenever you want, but you don't have to tap the funds if you don't need to. Essentially, it's a safety net, there when you need it. The other attractive feature, says Hollensteiner, is that closing costs are either very low or paid for by the bank itself.
Here's where things get tricky. The interest rate is usually tied to the prime rate, meaning that it can change at any time. As of early 2015, it happens to be at an all-time low, but it's most likely going to creep back up.
Then there's the payment structure. Typically, for the first five or 10 years, depending on the terms, you're only required to pay back the interest on the amount you borrow, which can seem very beneficial if you're struggling with cash flow right now. After that, however, you begin the principal plus interest repayment period, says Walsh. "Customers often get 'payment shock' after that initial period, so that's something to be aware of," he says.
Finally, in order to make a HELOC work for you, you have to avoid "deferring reality," says Michael Chadwick, CFP, CEO of Chadwick Financial Advisors. "If you have $30,000 in card debt and are paying $1,000 a month, and now you move to a home equity line, which has a $60 minimum payment, that can get you into trouble," he says. In other words, by just paying the minimum, you're not really taking advantage of the lower interest rate if you're stretching out the payments for many years. Remember, you still owe the money, but now it's against your home instead of to your plastic issuers. And, that home equity interest rate can shoot up at any time. "If you really want to improve your situation, try to make close to the same payment that you were making on the credit cards to the home equity line," he says. That way, you'll get out of debt for good, and faster than you would have thanks to the lower interest rate.
A cash-out refinance works like a regular mortgage refinance, except that the borrower tacks extra money onto the loan and takes it as a cash payout. "Most borrowers today are trying to do two things with a cash-out refinance: Achieve a lower interest rate on their home loan and utilize their available equity in some way," says Hollensteiner. Because it's just one loan that replaces your current mortgage, it's typically a fixed rate, so you don't have to worry about the rate increasing as you do with a HELOC. "A lot of borrowers prefer the stability and soundness of a fixed rate because they know they'll have that rate until the loan is paid off, and that can be comforting," he adds. There are some adjustable rate refinances, of course, but the majority are 30-year or 15-year fixed rate ones.
If you really want to improve your situation, try to make close to the same payment that you were making on the credit cards to the home equity line.
|-- Michael Chadwick
Chadwick Financial Advisors
On the other hand, because it's a new mortgage, consumers face hefty closing costs that are rolled into the new loan, and ultimately can affect how much cash back they'll be able to get. That's because lenders put a cap on how much home equity you're allowed to borrow, usually no more than 85 percent of the LTV (loan-to-value ratio). An 85 percent LTV on a home worth $300,000 would mean you have to owe less than $255,000 in order to qualify, or put another way, you need to maintain at least $45,000 in equity on the home after the refinance. So if you don't have much equity in your home to begin with, once you add in the closing costs, you might not come out with enough extra cash to tackle your credit card balances.
In order for it to makes sense, you'll need to crunch the numbers. Ideally, if you can lower your current interest rate and monthly payment even with taking the extra cash out, it can be a good move. Without a significant interest rate reduction, it makes less sense. "If you're a year or two years away from paying a debt, replacing it with a new loan that you pay for 30 years isn't necessarily the best strategy," says Hollensteiner.
As you consider your options, think about both the short-term and long-term benefits and costs, says Reiss. "You can't think of home equity as free money. That's your retirement, money you may leave to your children or use for an emergency. It's money that your future self may need," he says. If you do decide to move forward, make sure you're using your home equity wisely -- paying off your debt would fall into that category, as long as you commit to smart spending habits moving forward.
Take an honest assessment of where you are in life, and think through your ability to pay off the debt in whatever form it may take. "Run some numbers, and talk this through with someone whose financial judgment you trust," says Reiss. By being honest with yourself and becoming an educated consumer, you can figure out which option makes the most sense for you.
Example No. 1: HELOC versus credit card payoff
Assuming $20,000 in credit card debt. Illustrated with either a 36-month or 120-month payoff time:
|Time to payoff||36 months||36 months|
|Total paid with interest||$21,096||$24,956|
Savings using HELOC: $3,860
|Time to payoff||120 months||120 months|
|Total paid with interest||$23,760||$38,706|
Savings using HELOC: $14,946
*Note: HELOC interest rates do fluctuate over time, however, they shouldn't reach credit card-level rates, thus your interest savings should still be significant.
Example No. 2: Cash-out refinance
- Home value: $250,000
- Amount still owed on mortgage: $150,000
- Original interest rate: 5%
- New interest rate: 3.5%
With an extra $20,000 cash out and assuming $5,000 closing costs, your monthly payments on a 30-year mortgage would go from $805.23 to $763.38, and your credit card debt could be paid.
Note: Your equity, credit score, how long you've been in the home, how long you plan to stay in the home, and if you'll get a significant enough interest rate decrease should all be factored into this decision.
Published: April 27, 2015
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