Credit-Card Debt Vs. Home-Equity Debt

Rebecca Walker and her husband were anxious to refinance their adjustable rate mortgage. But a $7,000 home-equity loan (HEL) stood in the way.

The Walkers bought their house in 2003 with a 100% mortgage, and now the two debts combined were more than the home was actually worth. "No lender would touch us," the 28-year-old from Broomfield, Colo., explains. "We were told that if we could pay off the home-equity loan, then we would be in a position to refinance."

So they did. In March 2006, they transferred their home-equity loan balance to a credit card. Not only did this free them up to refinance the mortgage — but it turns out they also saved money by transferring the debt from a HEL to a credit card.

Walker transferred the $7,000 home-equity loan to an American Express credit card with a 3.99% rate on balance transfers for the life of the balance. That's less than the 6% on their home-equity loan, even after factoring in the tax benefits the Walkers enjoyed. "Overall, we'll save $750," Walker estimates. "For us, it's no small change!"

An alternative source for cheap loans

Turning home-equity debt into credit-card debt sounds like a dumb move. "It's conventional wisdom that if you have credit-card debt, you want to consolidate it into a home-equity loan," says Gary Schatsky, a fee-only certified financial planner (CFP) in New York. "To do the reverse goes totally against what we've been taught about being prudent."

Indeed, in the past several years, Americans massively pulled equity out of their homes, and used some of it to pay off high-interest credit-card debt. Back then, that made sense: Home-equity debt was as cheap as 4%, even cheaper when you factor in the tax deduction.

But the times are changing. The average home equity line of credit (HELOC) now stands at 8.7% and the average home-equity loan, at 8.2%, according to HSH Associates. Meanwhile, competition among the credit-card companies rages on. Attractively low rates on balance transfers — some of which are valid for the life of the loan — aren't difficult to find.

The result: If used under the right set of circumstances, Schatsky says, transferring home-equity debt to a credit card — however contrarian — can save homeowners big money.

When the numbers are right — meaning the interest rate is lower and you can afford the credit card payments (more on that below) — carrying credit-card debt is in fact safer than owing money to your mortgage lender, says credit expert Gerri Detweiler, author of "The Ultimate Credit Handbook." "If you're delinquent, a lender could move to foreclose with a home loan," she says. "With a credit card, it would move to collections and yes, you could be sued, but they can't take your house."

That said, such maneuvers aren't for everybody. You have to play by the rules and be aware of the potential traps. Here's what you need to know.

Be ready to make higher payments

Turning your home-equity loan or line of credit into credit-card debt will quickly backfire if you can't afford the new payments. And they will be higher. That's because home-equity loans or lines of credit are typically amortized over 10 or 15 years, while credit card minimum payments use a shorter horizon, Schatsky says.

Say, for example, that you have a $10,000 home-equity loan. Assuming it's a 10-year loan, your monthly payment will be $101. But if you transfer the balance to a credit card that requires a 4% minimum payment, your first monthly payment would be $400. (As you pay down the balance, those minimum payments will go down.) So before you sign up for a balance transfer, call the card company and ask them what your first payment would be.

Pick the right offer

First things first: If you're going to hand a massive balance over to a credit-card company, it's best you do it with a balance transfer offer that promises a fixed rate for the life of the balance. These offers range between 3.99% and 6.99% these days, with 4.99% being fairly common, according to Curtis Arnold, founder of the credit card web site CardRatings.com.

And while 0% APR offers may look tempting, be careful. Those typically last for six to 12 months. Once the promotional rate expires, you'll be hit with the card's regular interest rate, which can run 18% or higher.

Then, make sure the credit-card limit is high enough. Aim for at least twice the balance on your home loan, Detweiler recommends. This way, you credit score isn't likely to drop because of high utilization. When Walker accepted the card offer from American Express, she asked them to increase the limit to $20,000 from $10,000, so it wouldn't appear she owed too much. (She got approved for $30,000.)

Comparison-shop

When comparing different balance-transfer offers, don't forget the balance transfer fee, says Scott Bilker, publisher of DebtSmart.com. Fees have been on the rise and can go as high as 3% or 4% of the transferred balance, with no limit. In other words, you could pay $300 or $400 on a $10,000 balance transfer. Offers with no fee or one capped at $75 or $95 (the most common limits these days) are still available, however. Before you make that transfer, call the card issuer and ask for that deal.

And don't forget the tax break when comparing the interest rate on a credit card to that of your home-equity loan or line of credit. If your loan rate is 6.5%, for example, and you're in the 25% tax bracket, you're essentially paying 5.04%.

Don't be late

Once the loan is transferred, make timeliness your biggest virtue. Even one late payment will trigger a rate hike to the credit card's regular interest rate, or worse yet, its penalty rate. Your best bet: Set up an automatic online payment schedule through your credit card or bank. If you had a HELOC, don't close the line of credit after you pay it off. This way, if your rate spikes up you can always transfer the debt back into your home, Detweiler says. (You can't do that with a home-equity loan, though.)

Retire the card

Assuming you are using a new credit card, put it in a drawer and forget about it as soon as the transfer is done. (If using an existing card, make sure any previous balance is paid off before transferring a new one.) That's because if you use that card for purchases, those will start accruing interest at the regular rate. The reason: Banks apply all payments to the balance that carries the lower rate first. You may end up handing over whatever you saved on that balance transfer right back to the company that made it possible.