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Using a home equity loan for debt consolidation.

Tony has racked up $20,000 in debt on several credit cards which have an average APR (annual percentage rate) of 18%. Tony can get a home equity loan with an APR of 8%. Tony has heard that a home equity loan can be a good way to manage credit card debt but he is not clear about all of the advantages and disadvantages of borrowing from the equity he has in his home for debt consolidation. If a home equity loan is a suitable for his situation, what type of loan should he get?

Analysis: A home equity loan can be a very smart way to clear up credit card debt for two reasons: 1) home equity loans most often have a much lower interest rate than credit cards and other types of non-secured debt, 2) the interest paid on the first $100,000 borrowed is tax deductible where as the interest paid on credit cards is generally not tax deductible. Tony should consult a tax advisor for the specific tax benefits available to him.

Tony must realize that in taking out a home equity loan, he is reducing his equity or ownership that he has in his home. He is in fact borrowing from a portion of his home that he has already paid off so that he can have money to pay off his credit card debt.

While a home equity loan may be useful in clearing up Tony's debt, there may be situations where a home equity loan may not be good idea for debt consolidation. Say for instance that you had $5,000 in credit card debt. Taking out a home equity loan is not free - in addition to interest there are associated closing costs. It would likely not be worthwhile to take out a home equity loan and incur closing costs to clear up a small amount of debt.

In Tony's situation, he has a large amount of debt and the home equity loan interest rate available to him is much lower than his credit cards so a home equity loan makes sense. Which type of home equity loan is right for Tony? Tony has likely lacked financial discipline and that is why he is in debt in the first place. For this reason, Tony should get a standard home equity loan and not a home equity line of credit.

A standard home equity loan is a conservative loan choice that has fixed payments and a fixed interest rate. Home equity lines of credit should not be used for debt consolidation since a line of credit gives you have the option of making minimum payments on the amount owing - this practice can lead to an unpaid balance at the end of your loan which is a very similar situation to credit card debt.

If Tony is serious about being out of debt, he should cut up his credit cards as they could get him into the same situation once again.

More Related Information On...
tax benefits - see Advantages & disadvantages of a home equity loan, Uses of a home equity loan - Debt Consolidation
reducing equity/ownership - see Advantages & disadvantages of a home equity loan
the standard home equity loan - see The Standard Home Equity Loan
choosing a type of home equity loan - see Which home equity loan type is right for me?, Types of home equity loans
loan costs - see Loan Costs

More Case Studies:

  • Using a home equity loan for home improvements: Charlene and Russell are considering borrowing from their home equity to make home improvements. They have a rough estimate of costs and they plan on doing the work over the next year. What type of loan is right for them?
  • Should you use the equity in your home to buy a car? Christine wants a new car but she has no savings. Should she use a home equity loan to buy a new car?
  • Cash-out refinancing? John wants to borrow from the equity he has in his home but he is not sure if he should get a home equity loan or cash-out refinance?
  • Ramifications of accepting a loan offer. Milton is thinking of accepting a home equity loan loan offer. How will this affect future selling, future home equity borrowing and what will be the tax implications?

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