Wednesday, May 28, 2008

Guest Post: The Pitfall of Using Home Equity for Debt Consolidation

This is a guest post from Miranda Marquit, who edits debt consolidation information for If you are interested in publishing a guest post on Money and Such, take a look a these guidelines, and drop me a line. I am looking forward to hearing from you.

And now, to the post itself:

When you get into a great deal of debt, one of the tempting solutions is to use your home equity for debt consolidation. This can seem like a good idea, but there are pitfalls -- especially now that the housing market is struggling so much.

Advantages of home equity for debt consolidation. There are some advantages to using home equity for debt consolidation. It does make it easier to get a debt consolidation loan (if you are going that route). Additionally, you end up with a lower interest rate. An interest rate, mind you, that comes with tax benefits. So that can be a definite advantage to using the equity in your home for debt consolidation. But it may not be the best idea for you right now.

Disadvantages of home equity for debt consolidation. The biggest pitfall of using your home equity for debt consolidation is the fact that you are exchanging unsecured debt for secured debt. Unsecured debt is debt that isn't backed up by anything tangible. Creditors can try and get you to pay, and they can wreak havoc on your credit score, but that can't actually really force you to liquidate any of your tangible assets for payment. Secured debt, on the other hand, has a tangible asset to back it up. In the case of home equity debt consolidation, this asset is your home. You use the equity in your home to pay off your consumer creditors and the bank owns more of your house. This means that if you can't make payments, you lose what is likely your biggest asset through foreclosure.

Another issue is the fact that many homes are moving into the territory of negative equity, due to falling home values. You may take out a home equity loan now to consolidate your debts, but if home values fall further in the next few months, you could find yourself upside down on your mortgage. And, with home values as they are now, even a home equity loan may not cover all your debts. You may only have enough equity for 3/4 of your debt -- or less. This means that you still have multiple payments to make.

As an alternative to using home equity for debt consolidation, you can use a process of aggressive debt reduction to take care of your debts on your own (pay down the card with the highest interest rate first). Also, if you feel that debt consolidation is the easiest way, there are organizations that will help you consolidate your debt without a loan. Just watch out for high "administrative" fees and other costs. And, if you are concerned about your credit card interest rate, it is possible to negotiate a lower rate yourself. In some cases, you can even negotiate to close the account and finish paying off the balance at the lower rate.

Editor's Note: I am cetainly no expert on debt consolidation, however I do have legal training (which I have not used in over a decade). I believe that the statement claiming that lenders cannot actually force you to pay unsecured debt is not correct. The difference between secured and unsecured debt is that in the event your assets are not sufficient to cover all your obligations, creditors holding secured debt have precedence over non-secured lenders, i.e. they get paid first from their secured asset, and the non-secured lenders get whatever is left (if anything). Unsecured debt does not mean that your lenders have no recourse. They can still come after you, even though the process they need to follow to come after your assets may be more cumbersome from their perspective. Am I off on this? Anyone?


DanC said...

The Editor's note is correct on that point. Also, as with corporations, the fact that secured debtors are first in line allows them to give you better interest rates.

DanC said...

Sorry for the double comment, but I'm not understanding why you're saying to use a home equity LOAN as opposed to a LINE OF CREDIT.

Can you explain why in debt consolidation you would choose a LOAN?

miranda said...

You are right. I should have been clearer in the post. There is recourse, but secured debt gets first dibs.

Most people actually choose a debt consolidation loan as opposed to a HELOC. But both are loans -- and both put your house at risk.

Many people choose loans because it reduces the number of payments they have to make (simplifying the process) and usually lowering the interest rate. There are advantages, but one still needs to be careful when going this route. If your essential habits don't change, any type of home equity debt will only increase your overall debt.

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