13 Jun Options to dig out of debt

Q. I have some credit card debt I want to consolidate. I’m debating between using a HELOC or taking a zero interest credit card. What’s the best choice?
— Digging out

A. We’re glad you want to get rid of your debt.

Credit card debt consolidation, if implemented with the intention of paying off the debt in a timely manner, can have many advantages, such as transferring high interest rate credits cards to a lower interest rate card or instrument, said Joseph Sarnecki, a certified financial planner with U.S. Financial Services in Fairfield.

Sarnecki said this can result in savings on monthly finance charges while you pay off your debt, and you’ll have the added convenience of potentially having one lower monthly payment.

“Hopefully this is your goal, and the debt consolidation is not part of a strategy to `borrow from Peter to pay Paul,’ where ultimately you will end up in the same position and in some situations, worse off,” he said.

That being said, the two options you reference, a Home Equity Line of Credit (HELOC) and a zero interest rate credit card are solutions that are frequently used as debt consolidation tools, based on the amount of debt and intended payback schedule.

Let’s look at these strategies in more detail.

A HELOC is exactly what it sounds like: a loan used to access the equity in one’s home.

Based on the equity the borrower has in their home — which is used as the collateral — the bank will determine an amount that the borrower may have as a line of credit.

“Many lenders set a credit limit on the home based on its’ appraised value, minus any existing liabilities such as a primary mortgage — usually between 75 and 80 percent,” Sarnecki said.

He offered this example: If a home is appraised at $300,000, a line of credit at a 75 percent limit would be $225,000. If there is an existing mortgage of $125,000, the HELOC would be capped at $100,000.

“Just like a credit card that has a limit, you only pay interest on the amount you actually use,” he said. “So if your current credit card debt totaled $20,000 and that is all you accessed, your interest would be on $20,000, not $100,000.”

Sarnecki said the advantage of using a HELOC to consolidate your credit card debt is the interest rate you would be paying — currently anywhere from 3 to 5 percent — would be less than the likely double digit credit card interest rate you are currently paying.

Another potential advantage with the HELOC is the interest paid is tax deductible up to certain limits, compared to a credit card’s interest, which is not deductible.

HELOCs have some disadvantages, too.

The introductory interest rate you receive is typically variable, Sarnecki said, which means in any given year the interest you are paying may increase. But still, he said, even with a rate increase, you’re probably still going to pay a lower rate than on your credit cards.

“The other potential disadvantage when trying to pay down your debt, is in the initial years, most HELOCs are interest-only, so you are actually not paying down any of your debt,” Sarnecki said. “If you choose this route, it is recommended to pay above the required interest-only payment to begin paying down your principal balance.”

Also note that HELOCS may have fees and closing costs.

Now let’s take a closer look at zero interest rate credit cards.

Sarnecki said if you use this strategy to consolidate existing higher interest rate card balances, make sure the card allows for balances transfers, as some only offer the zero percent feature on new card purchases.

Also note the zero percent feature does not last for an infinite period, so you want to be aware of how long the offer lasts.

“If your balance is not paid off in the allotted introductory zero percent period, most companies will begin to charge double digits interest on the balance — back to where you started — and some will charge back-interest on your initial transfers,” Sarnecki said.

Other items to consider are if the card has an annual fee, balance transfer fee, or late payment fee which nullifies the zero percent offer, so make sure you do your research and understand all the benefits and potential negatives.

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This post was first published in June 2017.