The Dangers of Paying Off Credit Cards With Home Equity

When people accumulate a little too much credit card debt, there’s always a strong temptation to work out some sort of debt consolidation that will make the plastic go away in one fell swoop. On the surface this can seem like an excellent idea. But debt consolidation is really about converting debt from one type to another – without actually paying it off. There are all kinds of riskS to this maneuver, but especially when you use your house for the consolidation.

Here are five reasons you shouldn’t use your home equity to pay off your credit cards.

1. Increasing the Mortgage Puts Your Home at Greater Risk

Anytime you increase the amount of money you owe on your home, you also increase the risk of owning it. This is especially true if you use a home equity line of credit (HELOC) to payoff your credit card loans. A HELOC is really just a credit line secured by your house, and you’ll be moving your revolving debt from unsecured status to secured – by your house.

But that’s not the worst of it.

HELOCs typically come with variable rates, which is part of the reason they have lower closing costs than a traditional mortgage. Since the HELOC is secured by your home, the rate on it is generally lower than what it is for credit cards. But since it’s variable, it can change – meaning increase.

Nothing constructive will be accomplished if you consolidate a bunch of 10% credit card debt into a 5% HELOC, if two years later the rate on the HELOC is up to 10% – or higher. A large HELOC balance at much higher interest rates could threaten your ability to make the monthly payment on the home.

2. It May Not Be As Easy to Sell or Refinance Your Home With a Higher Mortgage

Whether your credit card debt is consolidated using a HELOC or a straight up refinance of your first mortgage, you will be increasing the indebtedness on your home. That will make it harder to refinance or to sell, should the need arise.

This can be a serious problem should the value of your property fall as it did in much of the country after 2007. A 25% drop in the value of your home could leave you “underwater” on your mortgage, if your indebtedness reached 80% of the original value. That could leave you trapped in the home, unable to sell or refinance it.

Even if values don’t fall, the increased indebtedness could leave you with less equity after a sale, and that would leave you with less cash to put down on your next home.

3. You’ll be Converting Short-term Debt to Long-term Debt

Credit card debt is short-term debt. But when you consolidate it on your home, it becomes long-term debt. You may be converting unsecured revolving debt to a 30 year mortgage on your home.

If your credit cards happened to contain – among other short-term purchases – last year’s summer vacation costs, then you will be paying for that vacation for the next 30 years. You may also be converting last years Christmas gift purchases, last weeks dinner at Olive Garden, and a whole bunch of Starbucks latte’s to semi-permanent debt. That’s a bad trade off, no matter how much you’re saving in interest costs.

4. Refinancing Your Mortgage Costs Money

Should you refinance your first mortgage to payoff credit cards, you will incur costs as a result of the refinance. These costs are generally between 2% and 3% of the new loan balance. On a $200,000 loan, you may pay $5,000 for the refinance. That means that the credit card consolidation was accomplished at a very high cost. For example, if the refinance was mainly to consolidate $50,000 in credit card debt, you will have paid 10% of that amount to make the refinance – up front!

The problem is compounded if you reset your mortgage term. For example, let’s say that you have 25 years remaining on your 30 year mortgage. In order to consolidate your credit cards, you refinance your first mortgage back to a 30 term. The payment may be lower than what you were paying for your old first mortgage plus the credit card payments, but you will have added an additional five years of payments to the back end of the loan.

5. One Debt Consolidation Will Beget Yet Another

We can categorize this this one under “moral hazard”. If you use your home to accomplish one credit card debt consolidation, you’ll use it again. That’s because the consolidation makes it easier to get into – and out of – credit card debt. Refinancing your home is a way to get out of credit card debt without actually having to repay the debt.

Anything that’s easy is something you’ll do again. Nothing is learned about the negatives of running up large credit card balances, because fixing the problem was so easy.

At least part of the reason so many people lost their homes in the housing and mortgage meltdown was because they engaged in serial refinancing for debt consolidation purposes. Sure, their homes increased in value over the years, but they consistently borrowed the equity out to cover non-housing expenses. Eventually, the perpetually rising mortgage balance outstripped even the sizeable gains in property value.

You have a chance to prevent that outcome, by not using your home as a debt consolidation scheme for your credit card debt.

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

All posts by Kevin Mercadante