Here's a question that I'm getting over and over: If you have a lot of credit-card debt, is it smart to refinance it with a home-equity loan?
Right off, I can think of two reasons to say yes -- and two to say no. First, the positives:
Credit cards usually charge 15 to 19 percent interest, while equity loans might be advertised at 10 or 11 percent. So refinancing can lower your monthly costs.
In addition, interest on the equity loan could still be fully tax-deductible. In fact, under the reform-of-the-tax-reform law passed by Congress in December, your writeoff could be even more liberal for 1988 than for 1987 (details below).
By contrast, the deduction for credit-card interest is being phased out.
But there's a big risk to refinancing, one that borrowers ought to weigh. Unless you're incredibly disciplined, your home-equity loan could wind up costing more than you would have paid on your credit-card debt. Here's why:
A home-equity loan is a second mortgage in modern dress. Instead of taking out one big loan secured by your house, you get a revolving line of credit.
Depending on the bank and your own creditworthiness, you can borrow 70 to 90 percent of the home's current value (minus any existing mortgages).
But you don't take that money all at once. Instead, it becomes a reservoir of cash, available whenever you need it and repayable on a flexible schedule.
There's the rub. The schedule is too flexible.
With a credit card, any particular charge is paid off within an average of 15 months, according to Spenser Nilson, editor of the Nilson Report, a credit-card industry newsletter.
But the typical home-equity loan tempts you into stretching your repayments over a longer period.
You might be able to pay only the interest for five to 10 years, which pares your monthly payments to a minimum. After that, the whole principal falls due, which may force you to refinance.
Many borrowers will simply carry their loans until the house is sold and repay the principal then.
The low monthly payments make the loan seem cheap. But because you're carrying it for such a long time, it will cost you far more than a credit-card loan that you pay off more quickly.
Furthermore, the true interest rate on the home-equity loan may not be as low as it seems. Most lenders charge closing costs just as they would on any other mortgage, although that varies by state.
There may be origination fees of 1 to 3 percent and annual fees of $15 to $100. All these charges run up the effective interest rate, says Professor Richard Morse of Kansas State University. A loan advertised at 10 percent could actually cost 15 percent over five years.
There's one other risk for undisciplined spenders. You might borrow against your home to clean up your credit-card debt, then run up your credit card all over again. You'd wind up with two loans instead of the one you started with.
Refinancing your debt with a home-equity loan is fine if: You find a loan with a low interest rate and low up-front costs, you pay it off fast and you resist new debt. Otherwise, forget it.
Two new laws apply to home-equity loans.
There now has to be a cap on how high a variable interest rate can rise. Where to set the cap is left to the lender, but most don't exceed 17 or 18 percent. This applies to all loan agreements signed after Dec. 8, 1987.
Also, starting in 1988 (for tax returns filed in 1989), there's a change in how much interest you can deduct.
This year -- on loans taken, or added to, after Aug. 16, 1987 -- your deductible loan normally can't exceed the cost of your house plus improvements, unless the money is used for education or medical bills.
Next year, you will apparently be able to deduct interest on a home-equity loan up to $100,000, regardless of how the money is used.