Pay Off Credit Cards With Home Equity: Secured and Unsecured Debt

After yesterday's article caused a bit of a backlash, I thought I would follow it up by covering the topic in detail.

First, here's one comment from reader Cat:

NEVER EVER replace unsecured debt with secured debt. To even give this subject a thought is irresponsible. If you are responsible enough to pay down your debt, you shouldn’t need to refinance your home.

Also, if you are having trouble making your payments, your credit score is suffering and you would likely not get a great rate on the refinance. Please post a follow-up article explaining secured debt and unsecured debt. You have misled readers today.

Thanks for not holding back, Cat. 🙂 Seriously, thanks for inspiring this post. You are right that this was needed. Not to be one to mislead my readers, here's the deal on unsecured vs. secured debt, and the question of using the latter to pay for the former.

Home Equity | Secured Debt

Secured debt is debt that has an asset legally attached to it. It's not just that you bought an asset; the asset is actually “attached” legally in the agreement. This asset is the “security” for the debt.

If you default on the loan (i.e. stop making the payments) the company that lent you the money for the asset will just come take the asset from you. It's their legal right under the secured agreement to do so.

Examples of secured debts: home mortgage and home equity lines of credit, auto loans, and boat loans.

Credit Cards | Unsecured Debt

An unsecured debt doesn't have an asset associated with it. You may have purchased an asset with the debt, but the asset isn't included in the agreement.

If you default on the loan, the company that lent you the money has nothing to take away from you. All they'll do is call and harass you and ruin your credit score, rightfully so. 🙂

Examples of unsecured debts: credit card debt, gym memberships, some personal loans.

Using Secured Debt to Refinance Unsecured Debt

That leads us to the issue at hand, should you use your home's equity (secured) to pay off your credit card debt (unsecured)? Initially, and in most cases, I would say no because you're moving debt from an agreement that could only cause harm to your credit score to an agreement that could actually cause you to lose your home.

If you default, you're back living with Mom and Dad (or worse, on the streets) because you didn't pay your debts.  Debt that was originally created to buy something that was likely a want instead of a need, like an XBox 360.

But is it “irresponsible” to even consider it? Let's examine a situation when it might not be irresponsible to pay off credit cards with one's home equity. Imagine a guy named Max suddenly owes $25,000 in credit card debt due to unexpected medical costs. His insurance just didn't cover everything. The interest rate on the card is 18%, the best he could get with his so-so credit score. Each month though he's making payments on time, even paying extra every once in a while.

Continuing with the example, imagine that just last year Max put down $25,000 (5 year's worth of savings) on his first home purchase. Therefore, he has equity sitting in the home and can now take out a home equity loan (at 10%) to pay off the credit card debt. In Max's situation, I'd say the home equity loan is a move to consider. After all, isn't it not that different than if he'd put 0% down and used the savings for the debt repayment? The small risk of transferring the debt (and having no equity in his home) is worth the savings in interest charges for a responsible guy like Max.

I realize the scenario above wasn't presented in the guest post yesterday, and that in most cases people use home equity loans just to get back into more debt. Still, I'm just trying to show that everyone's situation is different (the “personal” in personal finance) and financial products can be used both poorly and responsibly.

A Better Solution for Unsecured Credit Card Debt

A better solution for unwanted high-interest credit card debt, in my opinion, if you have a decent enough credit score, might be to do a 0% intro rate credit card balance transfer. Your debt remains unsecured, and you completely avoid future interest charges. Just be sure to quit using your credit cards after the transfer.  I've used transfers in the past to pay off credit card debt and come out on top.

I'd love to hear more of your opinions on this issue. Let me hear from you in the comment section below.

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  1. @ Glenn – Great question. I answered this in a post called: How to Prioritize Your Debts for Payoff.

  2. What if Max had both Secured Debt (Home Equity Loans) and Unsecured Debt (Credit Cards). And assume Max is able to cover all the Minimum Payments on this debt and still has money left over at the end of each month. The question is Where should he use this extra Money? Should he use this extra money to reduce his lower interest Secured Debt or his Higher interest Unsecured Debt.
    Conventional wisdome says he should pay off High Interest Debt First to reduce the amount of interest he will be paying. Which means he should pay off his Unsecured Debt First.
    But is this smart considering he also has Secured Debt?

  3. Thanks for sharing your thoughtful comment, Mike.

  4. Mike Sweeney says:

    I agree, JD. I think it also depends on each situation and with what each person is comfortable with or not comfortable with.

    To say you should never replace unsecured debt with secured debt can’t be applied across the board. If someone feels that way, that’s cool, I respect that. But it can be a very sound financial decision for other people who are ok with it.

    At the same time, to say you should always replace unsecured debt with secured debt doesn’t apply across the board either. There’re always other options. I like the 0% transfer, you can’t borrow money for much cheaper than that. However, you’ve got to pay the piper at some point and once that intro period ends, you’ll need to retransfer or consider other options.

    Everyone needs to weigh out their personal options and then make an informed decision based on their level of comfort.

    After deciding, the reason the debt is there in the first place also needs to be addressed and corrected. (ie: overspending, lack of budget, job loss etc…), otherwise debt may continue to increase with any option.

  5. @ JD in DFW – Thanks for stopping by and commenting. I like the way you laid that out. Your analysis says it a bit more concise than I did. 😉 Don’t ever make me go look up a word again though (…tacit).

  6. JD in DFW says:

    I think a lot of people overlook the risk of losing their asset when evaluating the attractive rate of a home refiance. However, it seems that if one is committed to paying off a debt that the replacement of unsecured debt with secured debt can be a useful means of doing so. There is a tacit assumption that one may not have to repay unsecured debt, because assets cannot be take from you. I would argue that the responsible thing to do is to repay all debt and do it in a manner that is the quickest. Despite the risk, replacing unsecured debt with secured debt may be the quickest (albeit riskier) manner.

  7. Ryan @ Smarter Wealth says:

    Replacing unsecured debt with secured debt is only a good move in certain situations. You need to be extremely diligent with your money and your asset needs to be pretty well covered anyway so that by replacing your unsecured debt you will not lose your asset.
    You can save money on interest this way.
    Having said that, if it were all maths and figures we would all be rich. The way we spend money is based on emotions, so I agree with you to not replace unsecured debt with secured debt

  8. Sorry if I seemed harsh, but I think this is a mistake that too many people have made. Even in the scenario presented let’s say Max’s health or financial situation gets worse – now his house is possibly at risk. What’s worse than being sick and in debt? Sick, broke and homeless.

    Thanks for the post today. At least now readers may be a little more informed when they make a decision.