Why Throwing Good Debt After Bad May Be Riskier Than You Think


Related Links

Ed McMahon's Painful Financial Lesson
How To Choose The Best Credit Card
Want To Keep Your Credit Line Intact? You Might Want To Move OUt To Florida 

While replacing high-interest debt with low-interest debt may seem to make sense on paper, it isn't necessarily the right decision -- particularly if you're prone to money troubles.

The average American household with at least one credit card carries more than $9650 worth of debt, according to 2006 numbers reported by CardTrak.com.

With credit card interest rates running anywhere from the low teens to the low to mid-twenties, reducing or eliminating credit card debt is a major priority for many consumers.

Interest rates on many loan instruments have risen over the last month due to increased concerns about inflation and the continuing scarcity of credit in the market. But the current rates for a home equity loan (about 7% to 8%) or a 15-year fixed-rate mortgage (6.02% with 0.7 points last week, according to Freddie MacFRE) are much lower than the typical rate charged on a credit card balance. (You can check out the most recent rates in your area by heading to the relevant sections on BankingMyWay.com.)

Say you've got a $10,000 balance on a credit card that has a 24% interest rate. On paper, it makes sense to pay that debt off with money from a home equity loan at 7.5%. The difference in rates stands to save you close to $1,650 a year, or almost $140 a month, in interest payments.

Sounds good, right? Well, not really.

By rolling your credit card debt into a home-equity loan, you've managed to use hard-earned, long-term equity from your home to pay off short-term debt. That trip to Cancun and the new plasma screen TV aren't exactly lifetime investments, and they are not the types of expenses you should be paying for with your home.

One of the reasons why the rate on your home-equity loan is so much lower that of your credit card is because your home serves as collateral. If you miss a few credit card loan payments, the interest starts piling up. Default on your home equity loan, however, and you stand to lose your home.

The first thing you should do if you are struggling to get out from under significant debt is to write down all of your monthly income and expenses. Separate out your fixed expenses, like a mortgage payment or rent, and your expenses that vary, like food, clothing, and entertainment.

If you note everything you spend money on (including the mochaccino you treat yourself with from time to time), you can figure out where the gap is between your income and expenses. This allows you to choose where to cut back on your expenses in order to close that gap, while still covering important items like housing, food and healthcare. Services such as Geezeo.com will help you do this.

If making your own budget is too difficult, or no matter how you shave and squeeze, you just can't seem to close the gap, consider contacting a credit counseling organization. You can find a reputable counselor near you via the National Foundation for Credit Counseling.

Together with a credit counselor, you may decide that taking out a home equity loan to pay off your credit card debt is the right move to make. But you first need to make sure your budget is solid. Risking your home won't make sense if you turn around and rack up even more credit card debt.

Show Comments

Back to Top