The following question was submitted to John Roska, an attorney/writer whose weekly newspaper column, "The Law Q&A," runs in the Champaign News Gazette.
Careful. A home equity loan puts your house at risk if you don’t pay. The reduced interest rate often isn’t worth that increased risk.
Right now, defaulting on your credit card debt doesn’t risk losing your home. They can sue, and a get judgment against you, but they won’t take your house.
A home equity loan changes everything. The whole point of that loan is the fact that they can take your house if you don’t pay. That makes borrowers much more motivated to keep up their payments.
Legally speaking, it’s the difference between secured and unsecured debt. Secured debt is backed by some collateral that can be repossessed if you don’t pay. The money from reselling the collateral helps repay the debt.
By increasing the chances of repayment, collateral makes lenders more secure. That’s why the collateral is called “security” for a debt, and why secured debts have lower interest rates.
House and car loans are almost always secured debts. Credit card debt, on the other hand, it almost always unsecured. Same with medical debts, and utility bills. If the debtor defaults, there’s nothing the creditor can repossess and resell to repay the debt with. All they can do is sue.
That lack of security explains the high interest rates on credit card debt. Thanks to the abolition of most usury laws, credit cards routinely carry interest rates over 30%.
So, using a home equity loan to pay off credit cards turns unsecured debt into secured debt. That’s only a good idea if you’re sure you’ll never default. Maybe reducing the interest rate reduces the payment enough to make that a good bet.
But if what attracts you is the convenience of replacing many different debts with one, and the payment on that single debt is still a stretch, a home equity loan is probably a very bad bet. If you don’t make each and every payment, you could lose your house, and be much worse off.
Beware, then, of turning any unsecured debt into secured debt through a home equity loan. Understand the trade-offs. The advantages—a reduced interest rate and payment, the convenience of a single payment—may not outweigh the big disadvantage of losing your house if you can’t pay.
That’s why avoiding a home equity loan, and leaving your credit card debt unsecured, is often best. Defaulting on that unsecured debt is much less painful.
Finally, you should be especially careful about a “consolidation” loan that both pays off credit card debt and lowers your house payment. That’s not a second mortgage, but a refinancing of your first mortgage.
A refinanced loan may reduce your payment, but only because you’ll be paying over a much longer period of time. In all, you’ll pay much more.