Because a home equity line of credit is a low interest, tax deductible loan, many people use a HELOC for debt consolidation or the purchase of a new car. But, is it wise to put your home at risk in order to pay off credit card debt or buy a new auto? It depends on a variety of factors, according to Scott Kays, President of Kays Financial Advisory Corporation in Atlanta, Georgia.
Kays is the author of Achieving Your Financial Potential [Doubleday] and Five Key Lessons from Top Money Managers [John Wiley & Sons]. He has also made a number of appearances on national television programs including ‘Your World with Neil Cavuto’ on Fox News and ‘Closing Bell with Maria Barturomo’ on CNBC.
Debt Consolidation & Home Equity Lines of Credit
According to Kays, it makes sense for people to use a HELOC to consolidate other types of revolving debt, especially credit cards with high interest rates.
“This would be a way to reduce your interest rate significantly, get tax benefits, make it tax deductible. If you’re actually going to be purchasing something, we would recommend your first choice would be to actually get a fixed loan for that period of time,” he said.
Kays emphasizes that people must be careful with home equity lines of credit because they’re easy to use and abuse. He outlines what he calls a nightmare scenario:
- the borrower has $20,000 in credit card debt
- the person consolidates all of the debt into a HELOC
- he runs up the credit card bills again
- he winds up not being able to pay the HELOC or the credit card bills
- the borrower’s house is at risk of foreclosure
“A lot of times people are just looking at how much they’re paying each month and not really paying attention to the balance of the loan and you can run up a lot of debt before you realize it,” said Kays. “If you’re not real disciplined, that is definitely a concern.”
Car Loans & Home Equity Lines of Credit
Kays says a HELOC is ideal for emergency purchases, such as replacing a broken refrigerator or other appliance. He says home equity lines of credit are not designed to be long term loans.
“The general rule is you want to match the term of a loan to whatever it is you’re borrowing to purchase,” he said. “If you’re going to buy a car and let’s say you want to pay it off in five years, get a five year loan as opposed to getting a HELOC for that because the risk is interest rates go up a lot over the next five years- especially as low as interest rates are right now- that is a very real risk. You could wind up paying a lot more than you anticipate up front in interest.”
Kays offered another “nightmare scenario” to illustrate his point:
- the borrower buys a new $25,000 car
- instead of getting an auto loan, the person decides to pay for the car through a HELOC
- the auto loan has a fixed 6% interest rate
- the HELOC has a 4% variable interest rate
- interest rates rise to double digits
- the person winds up paying double-digit interest on a $25,000 loan that he can’t afford to pay
“If they can’t remedy the situation, they could lose the house,” said Kays. “That would probably be the worst case nightmare scenario you could envision.”
According to Kays, a HELOC is an attractive loan that, when used shrewdly, can help a person with debt consolidation. However, home equity lines of credit should not be substituted for long term car loans. Kays says people should be disciplined when using a HELOC to avoid losing their home to foreclosure.