recent years, a popular but potentially dangerous trend has developed.
More and more consumers are taking out home equity loans to repay their
outstanding credit card debt. Many lenders have portrayed this as one of
the best innovations within the financial industry, but is this the truth
or just a way to boost profits?
A home equity loan, a loan based on the difference between your home’s appraised
or fair market value and your outstanding mortgage balance, is secured by
a second deed of trust on a house. The key is that this loan is secured.
Credit card debt is unsecured, which means that there is no collateral for
creditors to seize if you default on your loans. By converting this to secured
debt, consumers run the risk of losing their home should they fall behind
on the equity loan payments.
Let’s say you have $20,000 in credit card debt. You take out an equity loan
to repay the amount. Your credit cards are all at a zero balance again. However,
if you don’t realize how your balances got to be $20,000 in the first place,
what is stopping you from creating balances like this again?
People take these loans to ease the burdens of credit card debt. Unfortunately,
they often provide only temporary relief, and create bigger problems than
those they sought to eliminate. Just imagine having a mortgage, a $20,000
equity loan to repay, and running up another $20,000 in credit card debt!
Now you have real problems and stand to lose your house because you turned
your unsecured debt into secure debt through your home equity loan.
are some examples of the use of home equity to repay credit card debt.
• Example A: $20,000 equity
loan at 11% interest
• Monthly Payment: $227.32
• Total Interest Paid: $20,917.18
• Total Payments: $40,917.18
• Repayment Time: 15
Many consumers are attracted to home equity loans because they are told
that there will be substantial savings due to the tax deductions they may
be eligible for. The following example shows what those savings are. For
the purposes of this example, we will assume that the individual has an
income of $50,000.00 and is in a 30% tax bracket. The savings are realized
by deducting the interest you pay yearly from your income. For example,
in year one, the interest would be $2,172.55. This amount would be deducted
from the income. So the taxable income in year one would be $47,827.45
($50,000 - $2,172.55). Since you’re in the 30% tax bracket, your taxes
would be 14,348.24 (47827.45 x 30%). Without a home equity loan, your taxes
would be $15,000.00 ($50,000.00 x 30%). Your tax savings in year one would
be $651.76. Notice that the tax savings is 30% of the interest paid.
• Example B: $20,000 equity
loan at 11% interest
• Total Interest Paid (over 15 Years):
• Total Tax Savings (over 15 Years):
$6,275.15 (30% of $20,917.18)
• Total Interest Paid After Tax Savings:
$14,642.03 ($20,917.18- $6,275.15)
The Debt Management Program Alternative
take a look at how the same amount of debt would be repaid through a Debt
• Example C: $20,000 debt
repayment through a Debt
• Monthly Payment: $506.00
• Total Interest Paid: $6,990.00
• Total Payments: $26,990.00
• Repayment Time: 5 Years
the monthly payment of the equity loan is attractive, a consumer would still
save more through a Debt Management Program. In example C, the “Total Interest
Paid” through Debt Management would be $6,990.00. In Example B, the “Total
Interest Paid After Deductions” for a home equity loan is $14,642.03. Through
a Debt Management Program, the consumer would save $7,652.03
in interest and would only make payments for 5 years. Plus,
the consumer would not have to use their valuable home equity.
example A we used an 11% interest rate, which is commonly extended to individuals
who have a good credit rating. In the next example we will
use an 18% interest rate, which would be typical for a consumer from Massachusetts
who has less than perfect credit and must go to a sub-prime lender.
• Example D: $20,000 equity
loan at 18% interest
• Monthly Payment: $322.00
• Interest Paid: $37,997.96
• Total Payments: $57,997.96
• Repayment Time: 15 Years
are some negative aspects to these types of loans, the most severe being
if the borrower defaults, they could lose their home.
Also, the loan never addresses the problem of how the borrower got into
debt. If someone has poor money management skills, they may very easily
find themselves in a similar predicament down the road. Through Debt Management,
a consumer would not only save money and have peace of mind, they would
receive the proper education to avoid financial pitfalls in the future.