Paying off high interest credit card debt with a home equity loan can certainly help financially troubled families make ends meet. And in some cases the interest on home equity loan may reduce your tax liability.

Equity loans can work a couple of different ways. The first option is a fixed term and fixed amount. Typically these mortgages are made for periods of from five to twenty years. Each payment is the same and the loan is paid off at the end of the term. For example, you borrow $20,000 for ten years at a fixed rate and at the end of ten years the loan is paid off.

The second alternative is a line of credit secured by your house. The line of credit can increase and decrease just as a credit card balance does. The monthly payment is usually based on 1.5% to 2.5% of the outstanding balance. As with a credit card, this balance can go on almost indefinitely as long as the borrower pays the interest and a small amount of the loan principal each month. Many institutions will end the line of credit after ten years and require that the balance be paid off over the next ten years.

Lenders today allow borrowers to borrow up to 100% and even 125% of the value of their homes to consolidate debt. This means that when the homeowner sells the home, there is little or no equity to pay the cost associated with the home sale. These costs can be up to 10% of the sales price of the home when realtor fees and other expenses are added in.

And unlike the credit card debt, the equity must be paid off when you sell the house.
That can leave you in hole if your first and second mortgages exceed the value of the house. This can be a serious problem if you are forced to relocate or you just want to downsize your housing. Given the issues effecting home ownership, many borrowers might be better off to look for low interest rate credit cards.

Most lenders want an equity line to stop funding and start amortizing after ten years. That means that at the end of ten years you no longer have access to the line and it becomes a monthly payment just like a mortgage. Also, lines of credit usually have adjustable rates of interest. Typically such loans will adjust with prime, so in a time of rising interest rates, you can expect to pay more every time prime rate increases.

In the event of a bankruptcy, the homeowner must continue to pay on the home equity loan or face the possibility of foreclosure by the holder of the equity loan. Mortgage loans are not wiped out in a bankruptcy, as are credit card debts.

Just how many home equity loans result in foreclosure? According to the National Home Equity Association:

"About 2 percent of home equity borrowers default on loans and end up in foreclosure proceedings. This figure compares to 1 percent for prime loans and 3 percent for government-guaranteed mortgage loans."

This is logical since most homeowners will protect their homes and let unsecured credit cards go unpaid. But what happens when home equity loans are used for debt consolidation? Do consumers just run up their credit cards again? Some lenders go to extent of paying off credit cards with checks sent directly to the credit card company. Some even require that the cards be cut up.

Just how much that interest deductibility means to the average borrower is a subject for consideration. Consider the facts.

According to a recent study, the typical non-prime borrower is 48 years old and has an annual income of $34,000. And most of these loans are taken to consolidate high-interest debt or finance a child's college education.

Source: National Home Equity Association:

Obviously, to benefit from the mortgage interest deduction, a family must itemize its tax returns. At low-income levels, very few returns itemize deductions, while at very high-income levels, nearly all do. So, even though most of the wealth at low-income levels is in the form of housing, the mortgage interest deduction is scarcely used.

In order for a homeowner to benefit from the mortgage interest deduction (the amount of interest you paid on your mortgage for the previous year) you must have enough itemized deductions to total an amount greater than your particular standard deductions. Tax laws provide for interest deductibility under certain circumstances. It is important that you understand when it is not tax deductible. There are limits on the amount of the second mortgage. Visit the IRS website at www.irs.ustreas.gov/prod/forms_pubs/pubs/p93602.htm to review rules on interest deductibility.

©Gary R. Crum 2007 All Rights Reserved

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