While working as a bank manager, I learned about all sorts of fancy financial tools, and how you can combine some of them to build something even better. Two such tools are a home equity line of credit, or a HELOC, and a debit card.
Avoid Debt Wherever Possible
Before I get into how this works, I want to leave you with a disclaimer. Debt is a bad thing. There are some instances where debt can be used to help you improve your life, such as student loans or a mortgage, but if you are able to go to school or buy a home without a loan, that's even better.
So, while debt may have good uses in some instances, don't read into this post as a way to spend more money than you have. I have never done this myself, but I have helped people do this to lower their interest rate on outstanding credit card debt. If you have credit card debt and own a home, this may be very useful for you. If you know people with credit card debt, this may be helpful for them. But if you are already debt free, stay that way!
Leveraging Equity to Pay Off Debt
Okay, so let's say you already have credit card debt and you want to get debt free. Many Americans own a home and have substantial equity, but at the same time are paying credit card debt at a high interest rate, often near or above 20%. At the same time, a first mortgage loan has an interest rate around 4%-5%.
If you were to tap your home equity and refinance your mortgage, you could get a new mortgage, pay off all of your credit cards, and save thousands of dollars in interest as long as you keep good behavior and stay credit card debt free. The upside of this is a big interest savings. The downside is that if you stop paying, you lose your home.
I suspect financially savvy folks like you would not get into a situation where you are not paying off your home, so using debt consolidation to save money here is probably the best choice for you.
Creating a Home Equity Secured Credit Card
If you don't want to go that route, but still want to save on interest using home equity, your next best option is a home equity line of credit, or a HELOC. A HELOC has a higher interest rate than a mortgage, but because it is secured by your home, you can still save big over regular credit card interest.
While working at the bank, I met with a woman to discuss how to lower her monthly payments and get her credit card debt paid off in full. She had a hefty load of debt (in the $20,000 range), but she had another powerful tool: equity.
We discussed two options for dealing with her credit issues. She did not have a great credit score, so she did not qualify for many loans that were not secured. She owed on two cars in addition to her credit cards, and I came up with an idea.
First, we opened a home equity line of credit. A HELOC works like a credit card with no card, but the interest rate is much lower than a normal credit card. Instead of a rate around 20%, we were able to give her a rate around 5%. This saves a lot of money on interest and helps pay the loan of much quicker.
We then transferred her debt from the credit cards and the cars (which she then owned free and clear) to the HELOC. With her new minimum payment, she would be debt free in two years. This was about seven years less than it would have taken had she made minimum payments on the credit cards. In addition, her payments were lower. It was a win-win for her.
She wanted to close her credit cards so she would not get into trouble again, but wanted to keep something in case of emergencies. Fortunately, the HELOC still had cushion room on top of the balance she transferred in. I attached a bank debit card to the account and, abra kadabra, she had a low-interest, home equity credit card.
Since I am sure none of you have a lot of outstanding credit card debt, you can skip the middle part if you are interested in doing something like this. If you have a lot of equity, you can buy a car on the card and pay the low-interest rate of a HELOC, which would probably save you a few bucks, or a few hundred, in the long run.
The best part is that there are lots of tricks. If you have equity, you can do a whole lot with it. You are never stuck with high interest rates if you own something valuable, like a home. Have you ever created a custom loan for yourself? Let us know in the comments.
First posted January 13, 2009. Updated February 16, 2015.