By now you have seen ads touting the benefits of refinancing your home or taking out an equity line to pay off other high-interest debts and consolidate your payments. In theory, with mortgage rates at historic lows, the idea has merit. In practice, however, the risks are high and in most cases outweigh the potential benefits. Handle this badly and you will dig the hole even deeper.
Christopher HopkinsMany of us have fallen into the trap of carrying balances with outrageous interest rates due to unforeseen expenses like medical bills. Some are simply paying the tuition due from the school of hard knocks as we learn the benefits of financial discipline. Whatever the cause, digging out from under a pile of debt can seem daunting. The idea of using built-up home equity to retire those costly accounts can be tempting, particularly as many lenders are singing the siren song of low rates on debt consolidation loans.
This option should be reserved for only the most limited circumstances in which the borrower can be reasonably certain not to repeat the series of events that created the problem in the first place. Consider the following risks:
* Return trip. Reliable data is scarce, but financial counselors cite anecdotal evidence suggesting that recidivism is high. Estimates of failure range as high as 80 percent; that is, most borrowers who enter into consolidation loans end up with even higher debt levels eventually.
It requires a stout constitution to actually cut up the credit cards once the balances have been retired. Far too many fail to address the root cause of the indebtedness and end up back in hock to the credit card companies but this time with a higher mortgage payment. If you cannot be absolutely certain you will refrain from spending again, don't even consider a refi.
* Risk of losing it all. Most credit card debt is nonrecourse; that is, there are no assets backing the loans. In the event of default, bill collectors will hound you and you may ultimately need to seek relief in bankruptcy. A mortgage or equity line, on the other hand, is secured by a pledge of collateral. If you can't keep up with those payments, the bank will take your house. Converting nonrecourse debt into collateralized loans should be undertaken very cautiously, as failure to repay has significantly different consequences in each case.
* Indirect and hidden costs. Shifting retail debt into mortgage loans can pinch in other ways. If your mortgage debt exceeds 80 percent of the home's value, you will be required to purchase mortgage insurance. Also, there are closing costs associated with refinancing that can add up quickly and reduce the attractiveness of the transaction.
It also is possible that the consolidation loan could hurt your credit score, at least for a while. And stretching out your repayment over the life of a mortgage probably means you will spend more in interest payments over time than if you whittled down the credit cards over a few years. Converting short-term obligations into 15 or 30 year loans is a good idea only in rare instances.
Before giving serious consideration to an equity loan for bill consolidation, seek advice from a qualified, accredited not-for-profit financial counselor. NFCC.org and FCAA.org are two agencies that certify debt counseling firms and can help you find a local consultant. They can help you tackle the changes necessary to start reducing your debt and avoid falling back into the hole.
A consolidation loan is an option, but make it the last one.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.