After yesterday’s guest post, Would You Consider a Home Refinance to Pay Off Credit Cards?, 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 to even consider it? Let’s examine a situation when it might not be irresponsible to payoff 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 much 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 every one’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.