I Am Living Paycheck to Paycheck. What’s the Best Way to Clear My Debt?

Q: I have $33,000 worth of unsecured credit card debt. I’m not late on any payments, but I am living paycheck to paycheck. What’s the best way to clear my debt? Should I refinance my house or consider a debt consolidation company.  

A: I don’t think going to a debt consolidation company is the best strategy. And using a home equity line or refinancing your home may not be a smart move either, depending on why you got into debt and what your current situation presently looks like. When people ask me if they should use home equity to pay off credit card debt, here is what I tell them.

Using a Home Equity Loan

Getting a home equity loan or an equity line of credit can be a smart strategy for a few reasons. The interest rate on home equity loans (currently in the 6% range) is far less than what you’re probably paying on your credit cards (likely in the 15%-plus range). Additionally, the interest on home equity loans is tax deductible up to $100,000; the interest levied on your credit cards is not. Finally, from a credit-scoring standpoint, mortgage debt is treated more favorably than credit card debt, so converting that consumer debt is likely to positively impact your FICO score, by helping you reduce your credit card utilization rates.

A Strong Caution To Those Using Home Equity Loans to Pay Off Credit Card Debt

If you decide to consider this strategy, I have to issue a very serious word of caution: Don’t pay off those credit card bills, and put your home at risk with an equity loan if you’re just going to go back out and run up your charge cards again. The decision to take out a home equity loan is one that should not be made lightly. I believe that you should only use your home equity to pay off debt under two circumstances:

1)   You got into credit card debt because of what I call “The Dreaded D’s: (downsizing, divorce, death (i.e. a main winner in the family died), disability, disease, or some other disaster, like a business failure or lawsuit); and

2) The situation that threw you into debt has now been rectified. (For instance, you were downsized, but now you have a job, or you faced a disease or a disability, but now you’ve bounced back from your medical problems).

If you got into debt for other reasons of your own doing, such as over­spending, and if you haven’t learned how to get those impulses under control, I urge you to refrain from tapping the equity in your home to pay off credit card debt. I’ve heard heart-breaking stories of people who paid off their credit card debts by converting those obligations into mortgage debt – only to keep spending, not change their financial habits, and ultimately wind up losing their homes in foreclosure. I don’t want this to happen to you.

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