Be Wary of Using Home Equity to Pay Off Consumer Debt
Posted on September 14, 2007
You can’t turn on your television or radio without being bombarded with ads from financial institutions urging you to refinance your home. You’ve heard them; cut your interest rate, lower your payments, no closing costs and other reasons that seem too good to be true to do just that. The ads are so enticing they actually lead many unsuspecting people to believe they can borrow their way to prosperity. Have you ever wondered why banks spend so much urging people to consolidate debts? Here’s some food for thought.
As recently as 2005, the credit card industry was mailing over 6 billion credit card offers per year. That’s more than 6 per household per month. I must have been on their “A” list, because I was getting that many a week. (Mine slowed dramatically once I started writing “NOT INTERESTED” on the applications and returning them in the postage paid envelope along with their offer letters, envelopes and what ever other junk mail I wanted to get rid of.)
Coupled with this bombardment of credit card offers, was an explosion in consumer debt. It took Americans almost 220 years, from 1776 to 1994 to run up $1 trillion in consumer debt, but only 10 more for it to top 2 trillion. Today it’s closing in on $2.5 trillion and a huge portion of it is unsecured credit card debt. That leaves little doubt about why banks would love for you to refinance your home to consolidate these debts. They want you to secure them with your most cherished possession, your home. Banks are in the money business. They know that when people are short of funds they are more likely to skip credit card payments than risk foreclosure by not paying the mortgage payments on their home. As young people would say, Duh!
Last week I wrote about ways home equity could be used to build wealth. That’s entirely different from using it to finance day-to-day expenses. The recent run-up in real estate prices has caused home equity to double, triple and more in just a few short years. Suddenly people found themselves with huge amounts of equity that wasn’t doing much for them. Banks discovered this gold mine and began a big push to entice homeowners to pledge the equity in their homes to secure loans to pay off credit cards, buy cars, boats or recreational vehicles, take vacations and otherwise improve their lifestyles.
Low interest rates and growing home values during 2004 and 2005 brought huge increases in home equity lines of credit. During the third quarter of 2005, middle class households that used HELOCs, consolidated and secured an average of $12,000 of credit card debt with the equity in their homes. Many others established lines of credit they are currently using to finance a standard of living that can’t be supported with their regular income.
Sure, there are extenuating circumstances that make refinancing your home or getting an equity loan a sensible alternative, but doing it to simply pay off credit cards and other consumer debts isn’t one of them. While it may seem like a viable solution if you have overextended yourself, it can cause even greater problems unless you change the spending habits that caused the problem in the first place. Otherwise, you’re likely to find yourself in the same situation again the home equity that bailed you out already used up.
With banks holding more than $2 trillion in unsecured consumer debt, you can bet they’re going to continue urging homeowners to secure as much of it as possible with the equity in their homes. You’ll see low rate offers, no closing costs and other enticements to get you to do this, but before you jump on the bandwagon and take what seems to be an easy way out, stop to evaluate how you ran up the debts in the beginning.
Here’s a tip! It’s tempting to use a equity loan to mask poor spending habits, so do your homework before you borrow. Get a pad of paper and list everything you regularly have to pay each month. Be sure to include the payments you are making on all of your debts. Don’t forget to include the monthly amount of annual and semi-annual expenses like taxes and insurance. Once you have done this, subtract the total from your monthly income. Then deduct the amount you will need for food, gasoline, clothing and other necessities. What’s left is the amount you have for discretionary spending. Now you will be able to determine where the problem lies.
If you have been spending more than your discretionary funds, the difference has probably been adding to your credit card, department store or other consumer account balances. Little things we seldom think about can cause big problems. Just eating out once a week can easily add $200 - $400 per month to a family’s expenses. Going to a movie once a month can cost a family of four $50 - $100 after drinks and snacks are added. People get in financial trouble much more frequently because they fail to monitor the little things than because of the big expenditures they make.
Home equity is a valuable asset that when used properly and carefully guarded can build wealth and secure your future. But, if it’s used to support a lifestyle beyond your normal income, it can become an addiction and like other addictions it will require major lifestyle changes to correct. Be wary of using home equity to secure consumer debt. Use caution before you use credit!
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