Answer: You need to accept your new reality, rather than papering it over with ill-advised loans or raids on your retirement accounts.

That means reducing your expenses dramatically to reflect your new, lower income. If your housing expenses eat up more than a third of your current pay, for example, you need to consider your alternatives. You have equity in your home, which should make a sale easier. If you want to hang on to the house, consider getting roommates or even renting out the house while you live elsewhere (if the rent will cover your home’s monthly expenses).

You may have loan payments or other debts taken on when you had more income that you can no longer afford. If that’s the case, discuss your situation with both a legitimate credit counselor (one affiliated with the National Foundation for Credit Counseling at http://www.nfcc.org) and a bankruptcy attorney (find referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org).

Your home equity should be reserved for emergencies, not used to finance a lifestyle you can no longer afford. And your retirement funds should be left alone for retirement.

Answer: Creditors other than the federal government are not allowed to garnish your Social Security benefits. Many pensions are exempt as well.

Your equity in your home, however, may be fair game. States have “homestead exemptions” that protect a certain amount of equity in a primary residence, with the amount varying by the state. But creditors may be able to go after equity above those amounts, or any equity in a property that’s not your primary residence.

You need to find an experienced bankruptcy attorney familiar with the laws of both states to give you advice. You can get referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org.

That’s great news for folks who still have good credit, a job and some equity in their properties.

If you’re struggling, though, you may find help via a new government Web site that explains the new Making Home Affordable programs.

You’ll find simple quizzes to help you decide if you may be eligible for Home Affordable Refinancing (which can help those who have too little equity to qualify for regular refinancing) or Home Affordable Modification, which can help you keep your home if your payments are too high.

You’ll also find links to HUD-approved housing counselors, checklists to help you get organized and resources to consult for more help.

You may also want to read:

• Refi’ing with a HELOC? Bird-dog your lenders
• When to walk away from a mortgage
• Facing foreclosure? 9 options

Steve Rhodes, founder of GetOutOfDebt.org, recently echoed that advice (hat tip to CreditMattersBlog.com).

A Wall Street Journal columnist recently suggested borrowing against credit cards and using the cash to boost your emergency fund.

I know a few folks–homeowners and business owners–who tapped big lines of credit and stuffed the money into savings. They’re now patting themselves on the back for their foresight, even though carrying the debt is costing them hundreds of dollars a month.

Has the world gone mad? Not quite, when you consider:

• Most American households don’t have enough liquid savings to cover a typical stretch of unemployment, which in this recession is creeping toward 12 weeks (3 months).
• Half of households told MetLife pollsters that they were one month (or two paychecks) away from not being able to meet their financial obligations. More than a quarter–28%–would fall behind after missing a single paycheck.
• In the past, many would have turned to their credit cards or home equity lines of credit to pay their bills, but lenders are slashing access to that credit. Bankers are freezing or lowering limits on home equity lines of credit across the board, and one banking analyst has predicted that card card issuers will cut total limits by more than half in coming months.

Still, carrying expensive credit card debt–or adding more to your pile if you don’t absolutely need to–is a risky proposition, to say the least. You’re paying unnecessary interest, courting damage to your credit scores and putting yourself further at risk of the whims of your lenders, which can jack up your rates or change your terms at any time.

Furthermore, you need to be suspicious of any “one size fits all” advice, because everybody’s financial situation is unique.

The key in knowing what to do know is to gauge your total financial flexibility–your ability to pay your bills and cope with setbacks based on your available resources.

Here’s what I recommend:

Take stock of your own situation. See how much unused credit you have on cards and your home equity line. Check your FICOs. Get an idea of how much your home is worth and what the sales trend is–flat, declining, sharply declining. Figure out how much money you’d need to survive for at least three months and compare that against your cash stash and your access to credit.

Gauge your risk. If you don’t have much equity and home prices in your area are plummeting, you’re at high risk of having your HELOC frozen or the limit lowered. If your credit scores aren’t good to excellent (FICOs of 720 or above), or you’re using more than 50% of your available credit card limit, you’re at greater risk of having your limits cut and not being able to fight back by persuading the lender to rescind its decision or transferring your balances elsewhere. If you have only a few cards or lines of credit, you’re more vulnerable than if you have several accounts at different lenders. As I said last week and in my MSN column yesterday, diversifying our credit has become as important as diversifying our investments.

Make a plan. If your credit scores are great, you have tons of accessible home equity and there’s plenty of space on your credit cards, your financial flexibility is high–which means you needn’t panic and change your debt-repayment plan. Otherwise:

• If things are a little tighter, you might consider opening an escape hatch or two: another credit card if you can resist the urge to run up more debt, or a line of credit at your bank.
• If you have accounts that have already been frozen–the lender’s told you that you can no longer draw on the account–paying the minimums and stashing your cash may make sense, since you won’t free up any additional credit by paying the debt down.
  
• If you have a HELOC that’s at risk and you planned on tapping it in the next year–for college tuition, say, or to finish a remodeling job–get the money now.
  
• If you’re already on the edge, you have little financial flexiblity and a layoff would push you over, then by all means, conserve cash now. Pay the minimums on your debt. Think about the expenses you’d cut if you lost your job, and trim them immediately so you can put the extra cash into savings.
• If you’re really in deep, now may be the time to consider consulting a bankruptcy attorney–who can give you truly individualized advice, rather than generalizations that can turn around and chomp you on the butt.

Answer: Yes, your lender typically can reduce your line of credit when your home’s value falls. Since the drop-off in price has been so steep and your “loan to value” was already fairly high, you’re definitely at risk of having the limit reduced. “Loan to value” means the mortgage balance plus the limits on any other home equity loans or lines of credit as a percentage of the home’s current worth. Most lenders these days are wary if loan-to-value exceeds 80%. Some have trimmed limits when loan-to-value ratios exceed 60%.

If you were planning on tapping your line of credit in the near future, do it now while the money is still available. If your line of credit does get trimmed, you could shop around to see whether other lenders would give you more credit, but expect to have some trouble finding one these days that is willing to take a chance.

We have a total of $69,000 in education debt. We also have a home worth $400,000 and our mortgage balance is $266,000, plus a home equity loan with a balance of $14,500.

We make a good salary, have excellent credit, pay all our bills on time, and, if gas weren’t so darn high, we would have a decent amount of discretionary income.

 

Does a home equity loan make sense in this case?

Answer: Generally speaking, trading student loan debt for home debt isn’t a great idea.

Student lenders typically are much more flexible than mortgage lenders, with a wider variety of repayment options. You also can get a deferment or forbearance if you lose your job or otherwise encounter a financial hardship. This respite from payments can last as long as three years on many student loans.

Compare that with what would happen if you couldn’t make your mortgage payments. Within a year, and usually much less, your home lender would start foreclosure proceedings.

In addition, most student loan debt can be consolidated. This would allow you to lock in your current interest rate and perhaps lengthen the repayment term to lower your monthly payments.

A longer loan means you would pay more interest over time, but it could help ease the monthly crunch you’re feeling.

All that said, not being able to deduct the interest on your student loans is a significant disadvantage.

If you’re confident you’ll be able to make the payments, then you might consider paying off at least some of your student loan debt with home equity borrowing.

You should, however, limit your total borrowing — all your home equity loans plus your primary mortgage — to no more than 80% of the value of your house.

You want to keep at least a 20% equity cushion in your home whenever possible, as a last-resort emergency fund and also to protect yourself in case of declining home values. (You don’t want to be faced with having to sell your home and owing more than it’s worth.)

Given the loans you already have, you should be able to pay off $39,500 of your student loans with home equity debt. Then you could consolidate the remaining $29,500.