Using Home Equity to Consolidate Debt
If you’ve racked up a lot of of credit card debt — to the point that it has become difficult to make the minimum monthly payments — should you consider the use of home equity to bail yourself out? What are the tax consequences if you refinance your mortgage to utilize your equity to pay down our debts?
According to the finance columnist in the Monterey County Herald, if you utilize your home equity to consolidate debt, you may be able to wipe out those multiple nagging credit card payments, simplify your finances and lower your monthly debt expenses.
In most cases you can deduct the mortgage interest payment, which you can’t do with the interest you pay on car loans, credit cards, and private or personal loans.
There are several ways to convert the equity you have accumulated in your home to cash, including mortgage refinancing.
You may also be able to quickly tap into your equity by obtaining a 2nd mortgage or a home equity line of credit.
By refinancing, you are effectively turning the value of your home into working capital to consolidate your debts and improve bad credit. You are left with a single payment to your bank or your mortgage company that could offer better terms and a lower interest rate than your credit card obligations and other debts.
This type of mortgage loan often is referred to as a cash-out refinance or “cash-out refi.” For example, if your home is valued at $300,000 and your balance is $150,000, you might qualify for a 75 percent loan of $225,000 or more. That would allow you to repay the existing $150,000 balance and use the remaining $75,000 to eliminate other obligations.
If you choose the “cash-out” refinance option for consolidating your debts, compare the home equity loan rates and carefully evaluate your new loan terms and the tax consequences of refinancing.
When calculating the terms of your new loan against the outstanding debt obligations that you want to pay off, compare the interest rates.
Credit card interest rates often exceed 10 percent. New credit cards that promise lower interest rates may be offered at teaser rates that go up sharply in a short period of time. For example, if you paid off $25,000 in credit card debt with an APR of 13.99 percent with a cash-out refinanced loan of 7 percent, you would save approximately $1,300 a year.
Depending on how much you want to pull out from a “cash-out” refinancing, you may end up with a bigger loan and a higher monthly payment for which you must qualify. Still, refinancing usually guarantees a lower interest rate than most second or home equity loans.
When you refinance your home to pay off higher interest rate credit card debts, consider that you are trading off short-term obligations for long-term debt. While the payment is less because of the lower mortgage rates, it is amortized over 30 years.
Also, some lenders may be willing to offer you a bigger loan than necessary to pay off your obligations, and you may find yourself deeper in debt. Remember that you cannot borrow your way out of debt. A debt consolidation loan does not necessarily reduce the amount you owe. Instead, it will extend your debt further into the future.
Moreover, it may be tempting to max out your credit cards again after you have paid them off. If your purpose is to get out from under debt, put your credit cards away or at least formulate a disciplined plan for using them, such as paying off any credit charges every month.
The advantage of mortgage debt over other loans is that you cannot deduct interest paid on car loans, credit cards and personal loans. However, your home mortgage interest is only tax deductible if your loan is a secured debt in which you sign an instrument such as a mortgage, deed of trust or land contract.
Also, there is a ceiling of $1 million in mortgage debt when calculating deductible interest. The IRS expects to know how you are using cash-out refinance funds but does not preclude you from using the proceeds to pay off other debts. However, the amount cannot exceed 100 percent of your home’s value.
There are other factors that may affect the deductibility of your mortgage interest, including your original debt, the utilization of your cash-out proceeds and the basis of your home.
Stop, look and check your math before you decide to reduce your debt by tapping the equity in your home through a loan or a home equity line of credit. Weigh all your options. Think through the reasons for consolidating your debt. Is it to bring some discipline to your spending habits, simplify your debts or is it a way to reduce your monthly expenses?
Don’t forget to check with your adviser to determine your eligibility to write off the interest with the new mortgage, as well as the points and other costs that must be paid.
