“David Bach” “The Automatic Millionaire”

by David Bach

Posted on Monday, August 13, 2007, 12:00AM

I’m often asked if it’s a good move to pay down high-interest credit card debt using a lower-interest home equity loan or line of credit.

My short answer? No.

From Dream to Nightmare

According to the Mortgage Bankers Association, Americans had more than a trillion dollars in outstanding home equity loans in the first quarter of this year. It’s estimated that one in every three homeowners borrowing against their home use the proceeds to pay down credit card debt.

While this may make sense on paper considering the interest savings and tax deductibility, in my opinion using home equity to pay off credit cards could result in a financial nightmare.

So here are seven tips to help you make smart decisions about using — or not using — the equity in your home:

1. Don’t rely on home loans to pay credit card debt.

The primary difference between credit card debt and home equity loans is that the latter are “secured” loans. You’ve pledged your house as collateral against the amount you borrow. If you fall behind on your payments for any reason, you could potentially lose your home.

In my experience, when people borrow against their homes to eliminate credit card debt, they typically just slide right back into it — at the same level or worse — within two to three years. That’s because even after wiping the slate clean, they don’t change their spending habits. They max out their credit cards all over again and find themselves in an even deeper hole.

Is it possible to use your home equity to pay down debt and then stay out of debt? Of course, but generally those disciplined enough to pull this off don’t let their credit cards run amok in the first place.

Instead, I suggest calling your credit card company today and asking to have your interest rate lowered. It’s a simple phone call that takes all of five minutes. For more details, read my earlier columns “Five Steps for Ditching Credit Card Debt” and “What Credit Card Companies Don’t Want You to Know,” and check out the reader comments for more great tips on getting out of credit card debt without using your home equity.

2. Use home equity credit to build assets.

Besides a financial emergency, the most worthwhile reason to tap your home’s equity is for the purchase of, or investment in, appreciating assets. Buy an income-producing property or a second home and you’ve got a great investment.

Adding onto or upgrading your present home can be another good use for your home equity, if done carefully. According to Remodeling magazine, remodeled kitchens and bathrooms usually hold their value the best.

However, I think remodeling should be done primarily so that you and your family can better enjoy your home, not simply to try and increase its value. There’s always the possibility that the money you spend on home improvements won’t be recouped.

In addition, investing in your business or financing the startup of a smart new business could change your life. But notice the word “smart”: Many new businesses fail, so there are no guarantees. Still, this kind of investment is wiser than using home equity to pay for a credit card maxed out by unnecessary impulse purchases.

3. Learn how different home equity loans work.

There are two primary types of home equity financing:

• Home equity loan: Generally called a second mortgage, this type of loan allows you to borrow a set amount that you receive in a lump sum up front. You pay it back over a specified period (typically 10 or 15 years) in monthly repayments. The interest rate is usually higher than a first mortgage but lower than most credit cards, and fixed for the life of the loan.

•HELOC: This stands for “home equity line of credit,” and generally works like a credit card. Your lender assigns you a maximum amount up to which you can borrow. You can use only what you need if and when you need it, up to the limit. Interest is typically variable, but usually lower than credit cards because the credit is secured by your home.

4. Know your interest rates and terms.

First, shop around for the best rates (check out Bankrate.com or LowerMyBills.com to compare lenders’ rates). Then, see if your primary mortgage lender can offer you a deal. But make sure you understand how it works.

For instance, is the loan tied to the prime rate? Is it fixed or variable? Variable rates can hurt if rates keep going up. Determine when that variable rate adjusts and what your new payment amount will be when it does.

Read the fine print: Is there an origination fee (even if you don’t use the loan)? Is there a property appraisal or application fee? Will you incur closing costs? Will your payment amount increase if you’re ever late? And finally, are there fees if you pay the loan back early?

5. Get the tax deductions.

Just like with your first mortgage, the interest you pay on your home equity loan or HELOC may be tax deductible — by up to $100,000 — even if you’re not using the loan for home-related expenses.

Your deduction may be limited if the combined amount of your first mortgage plus any home equity loans totals more than the property’s actual value. For more information, check out IRS Publication 936.

6. Borrow no more than you need.

Ideally, I recommend keeping a minimum of 20 to 25 percent of equity in your home to ensure that you have a cushion should you ever find yourself in an emergency where you absolutely need to tap equity. This approach also grants you the peace of mind in knowing that you have some insulation against a declining real estate market.

To calculate your equity, simply take the current market value of your home and subtract all outstanding mortgages and home loans.

7. Don’t use your home loans like an ATM.

Over the past several years, lenders have made it excessively easy to pull money out of your house. Many new first mortgages come with complementary pre-approvals for generous home equity lines, often equipped with fast-access tools such as checkbooks and ATM cards.

While these are great tools of convenience, be honest with yourself about whether you’re responsible enough to handle the temptation.

The Ultimate Piggybank

Your home is very likely to be the foundation of your financial security. If you live off the equity in your home every three to five years by using it to pay off credit card debt, and then find yourself in a down real estate market like we’re currently experiencing, you could wind up owing more on your home than it’s worth.

This could lead to you being one of the millions who will lose their homes to foreclosure in the next few years. I don’t want that to happen. So please be careful, and think twice before you borrow to pay down those credit cards.

Your home is the ultimate piggybank — don’t break into it unless it’s a true emergency, or if doing so can truly help you live a richer life.