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Debt Consolidation – Equity

October 2nd, 2007 · No Comments

Another variation on “debt consolidation” is based on your ownership of real estate. If your home is worth more than you paid for it, you have equity, and many banks will gladly lend you money against it (assuming your credit report looks good enough). There is little risk to the lender, because if you default, they can force a foreclosure on your property to recover their money.

So, let’s say you have $25,000 equity in your house, and you find a bank willing to loan you $25,000 with your house as collateral. This is the ever-popular “second mortgage” or “equity line of credit.” You then pay off your credit cards. At this point in the program, things can go well or not so well. If you are a very disciplined person financially, and your hardship situation was temporary, you may emerge from the scenario with your credit intact. You still have the same level of overall debt, but it is structured in a way that you can live with.

Many people, however, find that they end up in worse shape using this approach. Why? Because they suddenly have $25,000 worth of credit available with new offers for credit cards coming in the daily mail. Then they get busy planning for the holidays, or they just have to buy that awesome home theater system for $3,500. Before they know it, they owe $10,000, $15,000, or even $25,000 again on those pesky credit cards, PLUS they have the second mortgage to keep up. The result is disaster.

There’s also another big problem with borrowing against your equity. You trade an unsecured debt for a secured debt. If you default on a credit card balance, the creditor (if you ignore the problem long enough) can sue you and obtain a court judgment. Then they can put a lien against your house, so that if you ever sell the house, you’re forced to hand over the money. But they cannot force the sale of your house. A secured debt is a far more serious matter, because you’ve pledged your house as collateral. If you default on a debt that has been secured by your house, then you risk losing that home.

Why trade unsecured debts for secured debts? For most people, this is not the best move to make. Yet countless individuals fall for this trap year after year.

Category: Credit