When it comes to borrowing money, it’s not uncommon for people to bite off more than they can chew.
Take Josh and his wife, for example. After the two had fully paid off their home in Seattle, they wondered what they could do with their newfound financial freedom. With a dual income of about $11,500 a month, no mortgage payments, zero debt and four children in private school costing around $3,700 a month, Josh and his wife felt financially secure enough to take on a new project: remodeling their home.
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But, as Josh explained on The Ramsey Show, he and his wife borrowed $105,000 via a home equity line of credit (HELOC) to remodel their house — and now they’re stuck, paying interest only, with no reduction in principal (1).
The couple currently owes a little more than $65,000 and is spending just $450 on interest per month on a variable rate. With this in mind, Josh asked hosts Jade Warshaw and Rachel Cruze if converting the HELOC into a 12- or 15-year mortgage would “fix” the stagnation.
“We’re not making any progress,” Josh admitted. “We’re just paying interest only right now and will for the foreseeable future.”
Here’s what Warshaw and Cruze had to say about the situation.
‘Where is all your money going, Josh?’
Josh’s situation shows how even people in strong financial positions can dig themselves into a trap, and it’s not just borrowed money that can throw a wrench in their finances.
After learning more about Josh’s situation, Warshaw and Cruze tried to get to the bottom of his issue with his HELOC. “You have no mortgage,” said Warshaw. “Where’s the problem here to pay $450 a month, or more? You could pay $1,000 a month to pay off this HELOC.”
Cruze doubled down on this line of questioning and asked Josh how much extra he could afford to pay per month in order to pay off this debt a little quicker. When Josh replied with “$500 a month,” the hosts had one simple question: “Where is all your money going, Josh?”
It didn’t take long for the hosts to figure out what was really going on. Despite taking out a large loan, Josh and his wife were still spending and saving as if they were debt-free, making the bare minimum payments on the HELOC and growing frustrated with the lack of progress.
Warshaw and Cruze offered a simple solution. “You don’t have a house payment,” said Cruze. “Shop at Aldi. Don’t go out to eat. Don’t go on vacation. Cut subscriptions. Do nothing until this is paid off.”
“Yes, and you’ve got the income to do it,” added Warshaw.
When Cruze mentioned that Josh surely should have at least $2,000 a month to pay off the HELOC, Josh disagreed. “I mean, not really,” he replied. “When we look at the numbers and where we’re allocating funds, like contributing to the Roths…”
But Josh couldn’t even finish his sentence before Cruze interrupted him. “No, stop it, Josh,” said Cruze. “Stop it. Stop the kid’s college, stop the retirement. Stop all of it, and get this $65,000 paid off.”
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How lifestyle creep may have played a factor
On the surface, it appears as though this couple is suffering from lifestyle creep, which refers to the tendency for people to increase their spending after a positive change in their financial situation. For Josh and his wife, paying off the mortgage and becoming debt-free likely made them feel financially comfortable with taking on an expensive project like remodeling their home.
But Josh and his wife went big, taking out a large loan to fund the renovations while likely not considering how the long-term commitment could affect their spending or savings. And now, with $65,000 left on the loan and their patience wearing thin, Josh and his wife are having a tough time balancing their HELOC debt with their expenditures and savings targets.
For this couple, converting the HELOC into a mortgage might feel like a plan that could provide some relief, but this move will simply extend the duration of the debt. Cruze referenced a rule of thumb: if the HELOC balance is less than half your annual income, as it is for this couple, you don’t convert it into a mortgage — you pay it down.
Likewise, Warshaw advised against converting the HELOC into a mortgage, saying, “this is risk on your home, right? And I don’t like this because it sounds like you’re averse to paying off debt, so this is a can that you’re going to kick down the road for a really long time. And I think you’re trying to put yourself in a position where you can kick the can down the road.”
As the hosts pointed out, Josh’s issue is that he doesn’t seem to be willing to curb his spending or pause contributions to his retirement accounts in order to tackle this debt. And Josh didn’t disagree, saying this after letting out a frustrated groan: “I’m 46 and stopping retirement (contributions) right now.” And, once again, Cruze had cut Josh off before he could finish.
“You’re 46 and took out $100,000 that you borrowed on your home,” said Cruze.
“That should make you more intense,” said Warshaw. “The fact that you said, ‘oh my gosh, I’m 46. I took out this HELOC. I have to pause retirement.’ That should make you go, ‘holy crap, I’ve got to get my butt in line.’ And instead you’re like, ‘oh man, I don’t want to do it.’”
How to avoid making Josh’s mistake
For anyone planning a home remodel and considering borrowing money to get it done, here are some important things to consider.
- Budget before borrowing. Know how much you’ll need to spend, how much you’ll need to borrow and how quickly you can pay off the loan
- Choose the right financing. A HELOC may be flexible, but it can become dangerous if you only pay interest. Borrowing money against the equity in your home can also put your most valuable asset at risk, so do your homework and figure out how much risk you’re willing to take on when borrowing money
- Match the payment schedule to your goals. For Josh, since his goal seems to be saving for retirement, he’d be wise to figure out a payment plan that allows him to pay off the debt as quickly as possible so that he can get back to contributing to retirement accounts
- Do the math on interest and total cost. With regard to Josh’s initial question for the hosts, mortgages often come with lower rates than HELOCs because they’re amortized, while HELOCs are variable and can increase in balance owed
- Pace the project and your lifestyle. Instead of borrowing for a full-house remodel, consider doing one project at a time. Meanwhile, keep discretionary commitments (private school, vacations, shopping sprees) in check until the remodel debt is cleared
- Avoid converting credit lines to long-term debt unless you’re ready to treat it like the priority it is. Rolling a HELOC into a mortgage means you’re pledging your home and extending payment years, which only works if you have a rigorous plan to pay off the debt.
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