Given all the attention generally paid to mortgages, and especially recently, you might think that the basic principles might be widely understood. Alas, no. See, for example, and I cite it only as a typical example, Suze Orman’s 2009 Action Plan, in which she addresses the advisability of borrowing using a HELOC (Home Equity Line of Credit, essentially a second mortgage on your house) to pay off credit card debt.
Do not do this. Even if you have enough equity to keep your HELOC open, this is a dangerous mistake. You are putting your house at risk. When you borrow from your HELOC, your home is the collateral. [page 30.]
That has a strong, almost visceral, intuitive appeal. And as strident as Orman is, she is fairly typical in her warnings against “putting your house at risk.” (See this from the Times a while back.) But it is pretty poor advice for many, probably most, people.
A mortgage on your house is a cheap loan, in all likelihood the lowest cost way you have to borrow money. The difference in interest rates between a credit card and a mortgage or a HELOC could be large, five or ten percent, even before considering that the mortgage interest is likely to be tax-deductible. That’s real money. The downside is that the loan is secured by your house. That’s not nothing, but it would only become meaningful in certain circumstances. Consider the following possible outcomes.
Scenario 1: You eventually pay off all your debts in full. If you used a HELOC rather than a credit card, the fact that more of it was secured by your house means that you paid a much lower interest rate before it was paid off.
Scenario 2: You file for bankruptcy. Actually this is two scenarios and the difference between the two hinges on state-specific details of bankruptcy law. If bankruptcy is a meaningful possibility for you, stop reading this now and go find somebody knowledgeable in your local area to help you out. If you are just interested in a generic understanding, continue on.
There is a thing called a homestead exemption. Basically, you get to shield $X of home equity from your creditors in the bankruptcy process. The catch is that you cannot shield it from secured creditors, i.e. the mortgage holder(s). And just to keep it exciting, the value of X varies implausibly from state to state. My own beloved Commonwealth of Massachusetts gives us $500,000, while Kentucky residents get only $5,000. You can find out more about each state here, but seriously, if your interest is more than academic call a local bankruptcy lawyer.
Scenario 2A: The mortgage/HELOC you are considering does not eat into your homestead exemption, either because you have practically no equity left in the house or so much equity that there is still more equity than homestead exemption after the new loan. In this case, that the loan was secured is important to the lender, but not to you. The secured lenders get paid first, leaving the unsecured ones to fight over what is left. You get to keep the same portion of your assets, you pay out the same amount of money, it just gets split up differently. A lot of the reason that secured debt is so much cheaper is that you are selling the lender a better place on line in case you go bankrupt. But that place on line often costs you nothing.
Scenario 2B: The mortgage/HELOC seriously eats into your homestead exemption. In this case a secured loan is a bad thing, because in bankruptcy you will have to use the otherwise exempted equity to pay the secured loan, while an identical unsecured loan might have been wiped out.
Scenario 3: This is the twilight zone in which you neither pay all that you owe nor file for bankruptcy. In this case, having a secured loan might be a lot less convenient than an unsecured one. Although an unsecured creditor can sue you for the money you owe, unless you owe rather a lot, and appear to be able to pay, they may not bother because the cost of dragging your sorry self into court is not worth it. A secured lender can, on the other hand, foreclose on the property, which is not only easier than suing you, it has a high probability of success. But note that a HELOC holder is less likely to foreclose. Although a second mortgage owner has the legal right to foreclose if not paid, they would then have to pay the first mortgage holder every dime owed before getting anything themselves. That can be problematic.
There is no question that for some people in some situations substituting a HELOC for a credit card is, indeed, a dangerous mistake. But I do not think it is true for most people most of the time. For most people, who will wind up paying what they owe, the practical difference between a secured and unsecured debt is a much lower interest rate. And even for those who do fall into the uncertain world of bankruptcy and foreclosure, it’s not so clear that they are always meaningfully worse off with a secured debt.
This is one of those rare areas of finance which is not a zero-sum game. Just because the lender is better off if the loan is secured, and is willing to pay for the privilege, it does not follow that you are worse off. Mostly, what you are selling the lender is a better position relative to your other creditors should bad things happen.
Of course, that’s bad for the other, unsecured, creditors and the fact that you might go and put somebody in line ahead of them just to get a better deal is one of the bad parts about being an unsecured creditor. And it’s one of the reasons that they charge so much. Put another way, credit card lenders bake into their rates a charge for the right to save money by putting somebody ahead of them on line. A reasonable person might think about taking advantage of that right.