Two years ago, I got divorced. Because I needed cash to pay my lawyer, I put my everyday expenses on a credit card. Before I knew it, between what I charged and the high interest rates, I was in considerable debt. I had a little over $17,000 on two cards.
I looked into transferring my debt to an 18-month no-interest credit card and spending every penny I could to pay off my debt before that interest kicked in. But when I ran the numbers, I wouldn't make it. I was already struggling to pay the combined $580 in monthly credit card payments. I realized I needed to free up cash each month, not tie up more trying to beat the 18-month clock. If I tried to beat it, I would be leaving myself cash poor, and I'd have no money if an unexpected expense occurred. Making the same monthly payments I currently make on the 18-month card was an option, but in the end, there would still be a balance to pay off. And, I'd be left with little breathing room in my budget each month.
After researching alternatives, I found that the best option for me was to use my home's equity. My ex-husband and I bought the home 20 years ago, but between several refinances, including one done shortly before we separated where we took significant cash out, there was still a mortgage on the home. I chose to keep the home and take on the mortgage alone so our children could stay in their school system.
Still, there was a good amount of equity in the house and I decided to borrow $25,000 of it so I could pay off my credit card debt, have lower monthly payments for some breathing room, and have some extra for any expenses that might come along.
In terms of accessing my equity, I had three options: Refinancing, taking out a home equity loan, or opening up a home equity line of credit. Here's how the pros and cons of each worked out:
Option 1: Refinance my mortgage
It would lower my monthly payment to $182.
If I refinanced my mortgage and took out $25,000 in equity, my mortgage payment would be $182 more each month—but that would free up about $400 for me each month ($580 credit card payment each month - $182 towards mortgage = $400 free).
The interest rate is higher than my current rate.
Interest rates have gone up since I first obtained my mortgage. My new interest rate would be 4.75, a half point more than the rate I currently have.
I'd have to spend cash to close.
I'd also have to pay $6,000 in closing costs (which would be rolled into the refinanced mortgage). Instead of adding $25,000 to my mortgage, I'd be adding $31,000.
I'd have easy access to money left over.
Once I paid off my credit cards, I would have about $8,000 leftover that I would put in a savings account as a buffer for unexpected expenses. Since I'm fairly confident I'm going to need tree removal on my property that will cost at least $4,000, I want the buffer, but having easy access to it isn't wise. I might be tempted to dip into that buffer from time to time for wants, not needs, justifying using "just a little of it" for concert tickets or a weekend trip that I "deserve."
Option 2: Home equity loan
It has a great fixed rate for the term of the loan.
A home equity loan has a fixed rate; the rate would never change throughout the life of my loan. I researched $25,000 home equity loans at two institutions—a credit union I belong to, and a local, small savings and loan bank. The savings and loan had the better rate for a ten-year loan: 3.75.
My monthly payment would be $250.
My minimum monthly payment would be $250, freeing up about $330 in cash a month.
I wouldn't have to pay extra to pay it off.
I could add extra payments to pay down the principal more quickly, and there would be no early pre-payment penalty.
No closing costs.
Unlike refinancing, I wouldn't have to pay thousands in upfront fees.
I'd have money left over.
With the home equity loan, I would need to take the entire $25,000 at once. I'd have the same problem I'd face with refinancing. There would be $8,000 at my fingertips, tempting me.
Option 3: Home equity line of credit
I could use as much as I need, when I needed it.
With a home equity line of credit, I'd be approved for the entire $25,000, but I'd only be charged interest on the amount I used. I'd use $17,000 to pay off my credit cards immediately and have the option of borrowing on the additional $8,000 if and when I needed it. And, as I paid back money, it would become available again for me to borrow from.
The interest rate is low.
The current annual percentage rate (APR) I could get for a HELOC is 4.127, amortized over 20 years. That means at first, more of my monthly payment would go to interest instead of principal, just like in the first several years of a traditional mortgage. However, because of the low interest rate, my monthly payment would be reasonable.
My monthly payment would be $115.
For the original $17,000 I'd draw on, my minimum monthly payment would be about $115, freeing up about $465 in cash each month.
I wouldn't have to pay extra to pay it off.
Like the home equity loan, there is no early prepayment penalty with a HELOC, but there is an incentive to add a little extra to the payment each month if I'm able to do so. That extra will go toward paying down the principal.
It's a variable rate.
A home equity line of credit has a variable rate, meaning it can change at any time. The rate is reasonable right now, but there is no guarantee that it won't go up in the future. In fact, the Federal Reserve has already raised interest rates twice this year, and it's expected to raise them again in the fall. However, my APR is guaranteed to never go above 10.174, which is much better than the current rate of 23.74 on my one credit card with the bulk of my debt.
The Winner: HELOC
Despite the variable rate, I decided my best option would be the home equity line of credit. Still, I wanted to know if there was anything else I needed to know, so I spoke with Stephanie Bittner, education manager at Clarifi, a non-profit consumer credit counseling service. She said besides the variable interest rate (the only con I thought of) there are two other big things to consider with a home equity line of credit: It's a secured loan and there are new tax implications.
"You are putting up your house as collateral," Bittner said. "If you get to a point where you are not able to make payments on the loan, the bank can come and foreclose on your property."
Finally, Bittner says tax implications have changed. "In the past," she says, "you could write off all the interest, but that changed recently. You can't write off the interest now unless the money from the loan is being used specifically to significantly improve the home or property." That new tax rule also applies to home equity loans. If I had refinanced my mortgage to access the equity, the interest would be tax deductible.
I was disappointed I wouldn't be able to write the interest off on my taxes, but I still decided the home equity line of credit was right for me. With it, I can pay off my high interest credit cards and ultimately pay less interest on the debt. I will have extra money to draw on if a big expense comes up, but that money won't be at my fingertips. And, most importantly, it will free up cash each month, giving me some breathing room with my monthly budget.
The fact that this is a secured loan is a bit of a concern, but unless there's a significant decrease to my income, I'm confident I can make the payments. The bank is, too. It approved my application, and I closed on the HELOC last week. I'm already breathing easier when I think about next month's bills.