There is a disturbing trend going on today: consumer debt is growing much faster than many individuals’ personal assets.
Historically, home equity lines of credit and/or home equity loans were developed for homeowners to repair, remodel or refurbish their homes. Taking out a loan on the equity and increasing the value of the home through the improvement creates a win-win outcome for the homeowner.
Recent studies have shown American credit card debt has grown to an alarming $850 billion since 2000. According to Robert Manning, a finance professor at the Rochester Institute of Technology, over $350 billion in credit card debt has been shifted into home equity loans or primary mortgage refinances.
Granted, using one’s home equity to pay off high credit card balances has its plusses. For one, the debt is consolidated into one payment (as opposed to several payments due at varying times during the month) and the interest is generally lower. Moreover, home equity interest is tax-deductible, like credit card interest was prior to 1987.
Unfortunately, however, with the current housing market crisis, many lenders have stopped offering home equity loans, tightened requirements, or have substantially increased the interest rate. Historically, where 4% was the norm, today home equity loans and/or HELOCS can be between 5-9%. Moreover, the interest rate increases as the loan-to-value ratio increases as well. Toss in a borrower with less-than-perfect credit, and he will be penalized with an even higher interest rate. With the recent drop in housing prices, the amount of equity against which to borrow has also decreased.
The largest argument against this type of debt transfer is that if hit with financial ruin or forced to declare a bankruptcy, unsecured credit card debt can be erased, but not a home equity loan. More stringent bankruptcy laws have eliminated this option. With the tightening of lender requirements, the increase in credit card late fees and interest rates, and the decline in the value of real estate, many people are finding themselves in a very difficult situation in a vicious cycle from which many don’t see a way out.
Most importantly, however, is that all of this analysis does absolutely nothing to address the underlying issue which contributed to the debt in the first place. Many consumers do not realize that they are already in debt when they turn to the equity in their home. By shifting the debt into their mortgage, they often see themselves as debt-free because the credit card balances are zero. Without setting a budget and learning to live within one’s means, this cycle will continue, and more often than not, the consumer is more likely to run the balances back up, oftentimes to a higher level than before.
1. Dugas, Christine. “Home Equity Loans Dry Up.” USA Today.
2. Saenz, George. “Loan Consolidation: Yes!” Bankrate.com.