IF YOU'RE A homeowner saddled with debt
(and we're talking about bad, high-interest debt like the kind
you pile up on credit cards) then Alan Greenspan has offered
you an escape route. How so? Well, while credit-card interest
rates have become increasingly immune to Fed rate cuts (with
the average card now charging 15.4%), home-equity lines of credit,
or HELOCs, have fallen to a paltry 7.2%. That's one of the lowest
rates we've seen since these products first became popular back
in the mid-1980s. And better yet, that rate is before you consider
the tax break on your interest payments.
Low rates combined with home values that appreciated
sharply over the past few years have homeowners rushing for
loans. "We're experiencing absolutely record volumes over
the last three months," says Doreen Woo Ho, president of
Wells Fargo Home Equity. Doug Perry of Countrywide's Consumer
Markets Division concurs: "With the prime rate really,
really dropping down, we've seen a real increase in home-equity
From a pure number-crunching perspective, consolidating
high-interest, nondeductible debt into a HELOC or a home-equity
loan, or HEL, is a no-brainer. Of course, your home is the collateral
for such a loan, and foreclosure could leave you bunking down
in Mom's den. So look in the mirror. If you're the type who
will simply accumulate more debt once you're wiped the slate
clean on your credit cards, forget the loan and pay a visit
to our Debt Management Center, where we encourage you to read
our article "Help! I'm Drowning in Debt."
Assuming you can resist temptation, however
(or if your debt was accrued because of a one-time expense like
a car, boat or unexpected medical bills), rolling over your
debt can save you loads of money. As you probably know, part
of the beauty of a home-equity loan is that up to $100,000 of
interest ($50,000 if you're married but filing separately) is
tax deductible. That's assuming your loan doesn't exceed the
value of your home (so stay away from those sleazy no-equity
loans). If, say, you're in the new 30.5% tax bracket, the after-tax
equivalent of a HELOC financed at 7.2% would be a mere 5%.
And consider this: If you had $10,000 worth
of credit-card debt at 16% and paid it off at $250 a month,
it would take you nearly five years and $4,400 in interest to
kiss it goodbye. But with that 5% rate, you'd pay about $1,000
in interest (keep in mind, this is after the tax deduction)
and could pay off your loan in roughly three-and-a-half years.
Have we convinced you yet? Well, before you
ante up the homestead, there's a fair amount you need to consider.
So here's a quick tutorial.
Debt Swap Strategies
These days, about 40% of the HELs and HELOCs
taken out are used for debt consolidation, according to a recent
study by the Consumer Bankers Association, making it easily
the No. 1 reason for taking out these loans. The runner-up is
home improvement, and certainly, in this environment, taking
out a loan for this reason can make sense, too.
But right now, the case for debt consolidation
is particularly compelling. That's because despite the prime
rate's having fallen 2.75 percentage points so far this year,
credit-card rates have proven surprisingly resilient. As of
the end of June, they had fallen only 1.04 percentage points,
according to figures from CardWeb.com. Some of that can be attributed
to cards that adjust only on a quarterly basis, but it's also
a reflection of interest rate floors combined with an industry
move toward fixed-rate cards, explains Robert McKinley, CardWeb's
Just three years ago, eight out of 10 cards
issued came with variable as opposed to fixed rates, so they
moved in conjunction with the prime rate. That proportion has
fallen to slightly more than 50% today. But even within the
pool of variable-rate cards, many are side-stepping rate cuts.
That's because as many as 25% of the cards, like the GM MasterCard,
have interest rate floors. In GM MasterCard's case, that floor
is 16.9%, which means that if you're currently a holder of that
card, your interest rate isn't heading anywhere but up.
But just because your credit card is a bad bargain
(and, hello, all credit cards are rotten deals once you decide
to carry a balance) doesn't necessarily mean you should take
out a HELOC. If you have less than $10,000 worth of debt (and
the average household with at least one credit card carries
about $8,000 in credit card debt), a smarter strategy is to
simply find a better way to budget yourself while also transferring
your debt to a credit-card with a lower interest rate.
This is in part because you often have to borrow
at least $10,000 to take out one of these loans, or at the very
least to qualify for the best rates. But it's also because you
just might find a slippery slope. People who take out home loans
for small amounts start to look at their homes as a treasure
chest to pay for other things, says Certified Financial Planner
Scott Kahan, president of Financial Asset Management. Once the
credit line is open, "suddenly they'll run up another $5,000
of debt here, they'll go on vacation all of a sudden
they've pulled out $20,000 or $30,000." Kahan says that
using a home-equity loan for debt consolidation makes the most
sense if you have serious credit-card debt, or perhaps credit-card
debt combined with other debt, like a car loan or expenses incurred
for remodeling your home.
The Three Options
So far we've mentioned two types of home-equity
products: Home-equity loans and home-equity lines of credit.
There's also a third option, known as cash-out refinancing.
Each of these can be used for debt consolidation, and each has
its pros and cons. Here's a quick review.
These days, the hot loan is the home-equity
line of credit, which works pretty much like a credit card.
You're given a maximum loan amount of, say, $20,000, which you
can then run up or pay off as you choose. Since lines of credit
are directly tied to the prime rate, these are currently the
cheapest loans in the home-equity market. This won't always
be the case, however. For as dark as the clouds overhead may
seem today, the economic picture will improve, and these rates
will head north when the time comes for Greenspan to tighten
things up. For now, though, given today's competitive market,
you can find HELOCs at the prime rate (currently 6.75%) plus
a small markup and teaser rates for a point or even more below
prime. Usually there are minimal or no up-front costs to take
out a HELOC, and the flexibility of these loans makes them ideal
for irregular expenses, like those that inevitably come up during
a remodeling project. It also makes them potentially risky for
those who can't have a line of credit open without maxing it.
A home-equity loan, by contrast, works a lot
like a mini fixed-rate mortgage. You get a lump sum, which you
are then expected to pay back via regular monthly payments over
a set amount of time. Rather than moving with the prime rate,
these loans tend to track short- and mid-term deposit costs,
explains Keith Gumbinger, Vice President of HSH associates.
These rates have been declining, though not as much as the prime
rate. Even so, the current average home-equity-loan rate of
8.49% (according to Bankrate.com) is fantastic for a fixed-rate
loan. Typically you'll pay fees and costs of somewhere between
$200 to $1,000 to take out a HEL, says Gumbinger.
A HEL can be handy for debt consolidation, since
you know exactly how much you owe on your credit cards, and
if you take out exactly that amount, you don't run the risk
of piling on more debt. Clearly, though, you're not going to
be doing yourself any favors if you spread out your debt over
the next decade, thus ensuring that those Jimmy Choo shoes will
eventually wind up costing you the equivalent of a year's worth
Finally, there's the cash-out mortgage refinance.
As the name implies, with this type of loan you refinance your
mortgage, taking out an extra bit for yourself. (Right now the
average rate for a 30-year fixed-rate mortgage is 6.83%, according
to Bankrate.com.) This can be a great move, but since refinancing
comes with its own costs, it's worth considering only if you
are already planning on refinancing. Also, if you do decide
to go this route, make sure you can pay ahead of schedule without
getting smacked with a penalty. After all, if you think financing
Jimmy Choo shoes over 30 years is a reasonable thing to do,
you should probably get in touch with a therapist in addition
to a financial planner.
So how do you find the best rates? Thorough
research, of course. Start with your local paper, but the old
adage "what the big print giveth, the small print taketh
away" certainly applies here, warns Joe Kennedy, president
of E-Loan. Often the best rates are teasers or apply only to
high balances. They also often don't include fees, like annual
charges, or early termination fees, which come with many HELOCs.
Also, keep in mind the rates quoted in newspapers are notoriously
low-balled, so don't be surprised if you find that the rates
that you get over the phone are slightly higher.
Be sure to check both the big lenders and the
little ones, advises Gumbinger. You'll often find that the best
rates are offered by local banks, savings and loans and credit
unions. Of course, as with any type of loan, the best rates
are going to be doled out to the best customers. So to qualify
for that 7% HELOC that some lenders are bandying about these
days, you need to have flawless credit plus a combined loan-to-value
ratio that's below 80% (meaning, your first and second mortgage
can't equal more than 80% of your home's value), says Kennedy.
But you probably wouldn't want to do that anyway. After all,
it's one thing to max out your credit cards, and quite another
to turn your home into a house of cards.