Refinancing to pay off bills doesn't get rid of the debt, it just moves it around

Cindy Sellers of Laguna Niguel, Calif., says she's no financial whiz, but when interest rates dropped and dropped and dropped, she decided it was time to refinance costly credit-card debt.

The 37-year-old mother of two and her husband, Stephen, a self-employed construction worker, traded their 23 percent credit-card debt of ,000 for a 10 percent home-equity loan that allows them to make more manageable monthly payments and extinguish their debt.

"I hated paying this useless interest," says Sellers, who notes that when the couple bought a home two years ago, all of their cash went into the purchase. When credit-card bills for the construction business started rolling in, cash was tight, and the debt piled up.

Today, Cindy Sellers doubles the minimum payment on the refinanced debt and still has a bit left to put toward retirement savings. She'll also get to deduct the loan interest at tax time. "I never thought that I would have credit-card debt, but I know I have to be smart about this," she says.

With mortgage rates hovering close to 20-year lows, and interest rates on second mortgages down, too, using your home to refinance and consolidate costly credit-card debt never looked so good.

Credit-card rates are averaging about 14 percent, according to bankrate.com. But many consumers' cards charge much higher interest rates.

Now, enter lower mortgage rates, which have dropped below 7 percent for a 30-year fixed mortgage. Rates on second mortgages are also bargains home-equity lines of credit are running about 6 percent, and home-equity loans are from 7.5 percent to 8 percent. Once consumers factor in the tax savings from writing off the interest on these mortgages, they often wonder why they should labor under hefty credit-card rates when they can consolidate their bills and pay one lump sum at a much lower rate.

It sounds good, but the strategy carries a huge risk.

"You're putting your home on the line," says Jim Frannea, president of Consumer Credit Counseling Service in Santa Ana, Calif. "You might lose it if you can't make the payments." A credit-card company, he notes, can't take your home.

At first glance, refinancing your first mortgage or taking out a second mortgage to pay off credit-card debt looks promising. And for some consumers, the plan can work.

But too often, consumers get carried away with their new, lower monthly payments and fail to look at the long-term consequences of extending their debt, Frannea and other experts say.

"All of a sudden, it's going to look like they'll have some extra money. The balances on the credit cards are zero, and it's tempting to spend," he says.

What's more, unless consumers beef up their monthly payments on the newly refinanced debt, they often end up extending their debt and extending interest payments over a much longer period of time.

"You could end up paying for some dinner you charged down at Denny's for 30 years," says Randy Johnson, a mortgage broker in Newport Beach, Calif., and author of "How to Save Thousands of Dollars on Your Home Mortgage." But what about the tax savings? In most cases, consumers will be able to deduct the loan interest on their taxes. But the tax savings will only give you back a portion of your overall interest costs.

For example, you say you don't mind extending payments 15 years because you get the tax break. But if your total interest costs over those 15 years break down to 5 a year and you're in the 33 percent tax bracket (state plus federal), you only get a refund of 2 per year.

Certainly, consumers who have the discipline to keep making large payments, cut up their cards and pay off their debt quickly can come out winners in the rate game. But before consumers place their home at risk when they merely want to pay off their credit cards, they should understand how the process works, and how easy it is to get caught in a debt trap.

Here are discussions of three options for paying off credit-card debt at lower home-loan rates: cash-out refinancing, a home-equity credit line, or a home-equity loan with suggestions for how to evaluate each one:

CASH-OUT REFINANCING

With cash-out refinancing, homeowners refinance their first mortgage for more than they owe. Then, they use the extra money to pay off their bills.

No one will dispute that now can be a good time to refinance. But if you are a homeowner who has been paying on a mortgage for some time, be sure to weigh the costs and benefits before using a refi to pay off your credit cards. You may find it doesn't make sense for you.

Many financial experts say it's never a good idea to refinance just to pay off credit-card debt.

"I don't think you should ever refinance to pay off debt unless you plan to refinance anyway," Johnson says.

Remember, when you refinance your first mortgage, you're starting over again on the term. So if you've paid four years on a 30-year mortgage and refinance, you're starting over again at 30 years. Also, by adding new debt to your mortgage, your credit-card balance might look nice at zero, but you haven't gotten rid of your debt. You've simply moved it around.

Here's an example of how a cash-out refi works.

The scenario: You have a 30-year, fixed-rate mortgage of 0,000 at 7.5 percent. Your monthly mortgage payment is ,398. However, you have credit-card debt of ,000 at 18 percent. You currently pay 0 a month on that debt. (At that rate, you'd polish off the credit-card debt in about four years.) You've been paying on your mortgage for eight years, so you've got 22 years left on it.

The low-rate deal: You'd planned to refinance anyway and can get a 6.5 percent rate. You also decide to refinance more than what you currently owe, so you can take the extra cash and pay off your high-rate credit-card debt. After you wrap in the refinancing fees and the extra ,000, you wind up refinancing a total of 7,000. (You use the ,000 to pay off your credit cards.) Your new monthly mortgage payment, which includes the debt, is now ,434. That is cheaper than paying ,058 a month the old mortgage bill of ,398 plus the 0 a month for your credit cards. How it can succeed: To put this low rate to work for you, Paul Scheper, a mortgage broker at Aliso Viejo, Calif.-based Loan Link, advises that you continue paying the same amount per month ,058 as you did with your old mortgage plus old credit-card bills. If you make that same payment under the lower mortgage rate, with the extra money going toward the principal, you'll pay off the new mortgage (credit-card debt included) in 14 years.

Your total interest payments in those 14 years: 8,744.

How it can be a debt trap: If you opt to pay only the new monthly payment of ,434, you're extending what would have been four years of credit-card payments into 30 years of mortgage payments. Also, when you refinanced, instead of having 22 years left on your mortgage, you're starting over at 30 years of payments. Your total interest payments in those 30 years: 9,240. In comparison, if you didn't refinance, the interest cost for the remaining 22 years on your current mortgage would be 9,072. That plus ,680 in interest on your credit-card debt would total 8,752. So think before you do a cash-out refi you might unwittingly pay the bank an extra 0,000.

Tips: If you decide to do a cash-out refinance and consolidate credit-card debt, make more than the standard monthly payment so you're not spreading the debt over 30 years. Many consumers are also doing cash-out refis to pay off their car loans. Johnson and others warn that you could wind up taking a five-year car payment and spreading it over 30 years. Your car will be scrap metal long before you pay it off. In the meantime, you'll have to buy another car and will be making payments on that loan as well as the 30-year mortgage that includes the old car loan.

HOME-EQUITY LINE OF CREDIT

In this scenario, you forget about refinancing your mortgage. Instead, you borrow against the equity in your home to pay off credit-card debt. After all, even though mortgage rates are low, home-equity lines of credit are even lower, with the national average around 6 percent. They are a type of second mortgage.

Rates on these credit lines are variable. They are pegged to the prime rate, which rises and falls depending on what Alan Greenspan and the Federal Reserve do to short-term interest rates. (This year, the Fed has cut short-term interest rates 10 times.) These lines of credit function like a checking account or credit card. You open a line of credit but don't pay anything until you actually use it to make a purchase or, in this case, pay off credit-card debt. Typically, the credit lines remain open for about 15 years.

The scenario: You want to pay off your ,000 credit-card debt. Again, you're currently paying 0 a month on this debt, but the interest rate is 18 percent. You can tap up to ,000 of your home's equity. You decide to open a line larger than your credit-card debt because you might need cash for emergencies. The low-rate deal: You get a line of credit for ,000 with an interest rate of 6.75 percent. You use ,000 of this line to pay off your credit-card debt. Once you tap this line, your monthly payment begins, and you will pay 5 a month (interest plus principal). How it can succeed: At this lower rate, if you continue to make 0 payments, just as you did on your credit cards, you'll get rid of that debt in three years. Not only do you pay it off a year earlier than if you'd labored under your current credit-card deal, but you also will save ,260 in interest costs.

How it can be a debt trap: If you only pay the 5 a month instead of beefing up the payments, you're extending what would have been a four-year debt into 15 years. You'd pay ,100 in interest costs. And that's assuming no change in the variable rate, which is currently so low. In reality, it will rise and fall, so your payment will vary.

Here's an even bigger trap: Many lines of credit allow you to pay only interest on what you borrowed, in this case 3 per month. After 10 years of paying this interest, your lender will tell you that for the remaining five years of your credit line, you must make a set payment in order to pay it off in time. So you go from payments of 3 a month to 3 a month for the last 60 months.

What the lender will most likely do, Scheper says, is allow you to renew the line for another 10 years, so you won't have to deal with those hefty payments. In essence, you're once again delaying your debt payments and again paying dearly for it in interest.

Tips: "Don't be fooled by the lower minimum payments," says Greg McBride, a financial analyst at bankrate.com. "The benefits of tapping into your home's equity are the lower rates and the tax advantages. But to take advantage of those benefits, you have to stick to a good payment schedule. You must step up your payments," he says. Also, lines of credit come with variable rates. That means when other short-term interest rates rise, the rate on your line of credit will rise, too. Rates are at a low point in the cycle, but at some point in the life of your credit line, they will rise, and so will your monthly payments.

Finally, understand that it may cost you to set up a line of credit. Costs range from nothing up to ,000. Lenders base these fees on your credit score, income and available equity in your house, Scheper says.

Always ask about how your payments are structured (you want interest and principal not interest-only), if there is a fee to access the credit line, if there is an annual fee for the line (typically the fee of to is waived the first year) and if there are prepayment penalties. In some cases, if you pay the line off in the first three years, you could face a penalty of 0.

HOME-EQUITY LOANS

Another alternative to a cash-out refinance is a home-equity loan. Like lines of credit, home-equity loans are considered second mortgages that tap the equity in your home.

However, unlike a line of credit, home loans carry fixed rates, which is why they are often called a fixed-term second mortgage. Because the rate is fixed, it is higher than what you'd get on a line of credit.

Home-equity loans are averaging 7.5 to 8 percent right now. That still beats credit-card rates hands down.

Home-equity loans have preset terms. You borrow a set amount and pay it back at a fixed amount each month for the life of the loan. Typically, consumers will get a 15-year term but lenders also see many 10-year terms and even 30-year terms. The scenario: You want to pay off that pesky ,000 in credit-card debt on which you're paying 0 a month (at a rate of 18 percent).

The low-rate deal: A home-equity loan at a fixed 7.25 percent for 15 years. Your monthly payments are 1.

How it can succeed: This is a sweet deal if you keep paying your current 0 a month at 7.25 percent. You'll get rid of the ,000 in 38 months (slightly over three years) and pay ,080 in interest. (That saves you ,600 in interest compared with the ,680 total you'd pay at the 18 percent credit-card rate.) How it can be a debt trap: As in all of the cases, if you're only paying the 1 a month and extend the term of the debt, you wind up paying more in interest costs. In this case: ,180. Tips: Most of the time, you can prepay on home-equity loans without fear of an early payment penalty. But just like lines of credit, equity loans can come with fees, so inquire about possible charges. Many financial experts like home-equity loans because consumers are borrowing a specific amount. They're not keeping a revolving line of credit open, so they aren't as likely to draw on it.

Scheper favors the 15-year fixed term because of its predictable nature.

You know what the payments will be each month. But you must have the discipline to pay off your loan and keep your credit cards free of debt.

"It's the yo-yo borrowers who will come back to us to refinance their debt again," Scheper says. "You cannot borrow your way out of debt. Eventually, it can catch up with you if you don't follow through with your plan."

Related links:

1. Should we Refinance? You mean you haven't yet? Where do we start?
2. Want to cash in on cash-out re-fis? Hurry
3. How low will they go?;