You racked up credit card debt over the years. In the meantime, you paid down your mortgage over the last 10 years. Combine that with the appreciation your house experienced and you have quite a bit of equity in the home. Should you use that equity for debt consolidation? We will discuss the factors you should consider to help you make the right decision.
What Type of Debt do you Have?
The first step is to lay everything out. Take a close look at the type of debts you have. This means every credit card, personal loan, car loan, and student loans. Write down the balance, monthly payment, and interest rate. This will help you see the big picture. Looking at your total credit card debt can be very eye opening, so be prepared. The average family carries more than $15,000 in credit card debt. It can happen so easily because swiping is much easier than handing out cash.
Once you know the types of debt you have, total each category. For example:
- Credit card debt $10,000
- Car loan $25,000
- Student loans $15,000
This way you can see where your money goes. Also, keep in mind the interest rate you pay for each type of debt. Credit card debt will likely take the cake on interest rates. Any unsecured debt usually has a much higher interest rate than secured debt, such as a mortgage.
Considering Debt Consolidation
Now that you see what you pay each month, you probably want to get rid of the debt fast. A debt consolidation loan might seem like the right answer. You get to put all of your debts into one loan. This means one payment each month. It probably also means a much lower interest rate. Mortgage interest rates vary between 3 and 7 percent while credit card interest rates can hit 25% or higher.
Consolidating your debt is not always the right answer, though. Remember, credit card debt is unsecured. This means you do not have any collateral tied to it. If you default, the bank cannot come after your home. They could file a judgment against you, but that takes a lot of time to make happen.
Your mortgage has collateral tied to it, though. That collateral is your house. If you stop paying your mortgage, the bank takes your house. There is no way around it. If you tie your credit card debt to your house by consolidating it into a home equity loan or cash-out first mortgage, you could lose your house if you do not pay the mortgage.
What can you Afford?
You need to know what you can afford before you consolidate your debt. Generally, your house payment should not exceed 28% of your gross monthly income.
An example:
Joe makes $75,000 per year. This means his gross monthly income equals $6,250. Of that $6,250, no more than $1,750 should go towards his housing payment. This includes his real estate taxes and homeowner’s insurance. If Joe can secure a mortgage with debt consolidation that includes his taxes and insurance for no more than $1,750 then it may be a good choice for him.
If the new mortgage payment for the loan that pays off his credit cards exceeds $1,750, it could be too hard to afford. Now he not only puts himself under financial strain, but he puts his house at risk. In this case, it would not be wise.
Joe’s example illustrates why you have to carefully analyze the situation. Do not look only at the interest rate. Yes, it can be exciting to save 15% per month in interest, but if it puts your house at risk, it is not worth it.
If you were to get into a financial jam, you could file for bankruptcy. This allows you to write off your credit card debt while keeping your home. Of course, this is a last resort, but it does not affect your home ownership.
Obviously, the best thing to do is avoid using credit cards and only pay cash for items you can afford.
How Much is Your Home Worth?
The value of your home is a major consideration in any refinance. You need to know a realistic number from an appraiser. This way you will not receive an inflated value just to get you to take a new mortgage. The appraiser can tell you what homes in your area sold for recently to give you a ballpark estimate of how the area is doing.
If your home is not worth enough, you could lose money down the road. You have to think of the future. Will you stay in the home forever? If so, the appreciation is not an immediate concern for you. However, if you know you may move in 5 years, you need to know how to proceed. If you take out too much of the equity of your home, you may land upside down on your mortgage. This leaves you with a loss when you sell.
What are Your Spending Habits?
You also need to think about your spending habits. If you qualify to include your credit card debt in your mortgage, that is great. You wipe the slate clean. Now you have credit cards with available balances. Are you disciplined enough to leave them alone? You should not close every account you have because your credit score could drop. But, you also do not want to rack up any balances again. You will be right back at square one if you do that.
Before you refinance, think about the things you charge. Are they daily living expenses? If so, determine if you can budget those expenses into your regular budget. Take the credit card availability out of the equation. If you cannot afford your lifestyle without them, think about what you will do. If you cannot make any changes, chances are you will use your credit cards again. This could deplete the efforts of the debt consolidation refinance.
Before you make any decisions, really consider the options you have. Whether you take a first mortgage cash-out refinance or a home equity loan, they both affect your homeownership. Consider carefully the savings and implications of including your debt in your mortgage.
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