Is it a good idea to take out a refinance home equity loan?

Slowly it crept up, and now faced with debt the offers for more credit cards start coming in. There is equity in the home, and those offers to refinance to pay off other debts are sounding more and more appealing. Does it make sense to tap equity in a home to refinance other debts?

The answer is, depends. There are some factors, which must be considered. First, are you prepared to risk the asset that keeps you warm at night? Some analysts advise on never taping those things, which are necessary for food clothing and shelter. Taping into the equity in your home may provide immediate relief but what happens in the long term if you are unable to pay it back or the mistakes made (if any) to cause the situation you are now in are repeated?

If you have a lien against the house you cannot pay, you could end up homeless and in a worse situation. Debt cannot be paid off by making more debt, it is a simply a shell game. The key is to find out how you got there and guard against it ever happening again, then reducing expenses to help pay off the debt as quickly as possible and avoid new debt.

Refinancing through a home equity loan, however, may be an option if there is no threat on missing a payment. Then the key becomes determining the cost of refinancing. If the interest rate on refinancing through a home equity loan is lower than the other debt, and it likely will be, then that is the first hurdle. If it is higher, then it is likely your monthly payment will be significantly higher or the amount of time to pay it off is significantly reduced. Avoid refinancing.

If the refinancing interest rate is lower, consider the term of the loan and the frequency of compounding. The lender should be able to provide you with an annual percentage rate. If the home equity loan is 10% and you are paying 20% on credit card debt, and each month you make a payment of $250 towards a $1,000 debt, it will take seven months to pay it off by the 10% loan, and 10 months by the 20% loan. It makes sense at this point to refinance because you will pay the loan off faster, spend less on interest, and possibly have a tax deduction.

This of course assumes there are no origination fees or closing costs on the refinancing. If there are, you must add those in to the total cost of your loan. It also assumes there are no fees for early pre-payment. Be careful of some of the “deals” out there designed to lower you monthly payment. Lowering your monthly payment may look good, but often they extend the life of your loan so that you actually end up paying more over time.

This may be beneficial if it frees up cash flow needed now, or in freeing up cash you can invest it elsewhere at a higher interest rate then the cost of the new loan. It requires a careful look at all the parameters. Also be sure to determine if the equity loan has other additional costs associated with it that would cause you to purchase additional homeowners insurance or private mortgage insurance.

There are many good resources available to compare options. Search for time value of money, and loan comparison calculators. Financial software packages, like Quicken, provide tools for determining whether one loan is better than another. Consider what your options are both long and short term, by weighing in your present situation with the total cost of the loan.

The best solution when in financial trouble is to not panic but weigh all the options. Take a realistic look at where you are, as hard as it may be to stomach. Then map out what is your best course of action, long and short term. A house is a powerful financial tool, use it wisely, else a bad situation now could end up in disaster.

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