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Debt Consolidation

Debt consolidation programs come in two flavors:

  1. A secured loan, (like a home equity or home improvement loan) taken out to pay off your smaller accounts, and
  2. An unsecured loan, such as a signature loan from a bank, or a new credit card.

When you consolidate debt, you enjoy the convenience of paying a single creditor under new terms. When shopping for a debt consolidation loan, the new terms should ideally be better than the terms of the accounts you are consolidating. With the right loan, the savings can be significant.

For example, say you owe $20,000 on 2 credit cards, your average interest rate is 22%, and your minimum monthly payments total $700. If you were to continue making minimum payments and not make any more charges, it would take you 41 months to pay off those cards and cost $28,700. If you managed to qualify for a debt consolidation loan for $20,000 at an interest rate of 12%, and managed to keep your minimum payments of $700 per month, you would pay the loan off in 34 months and save almost $5,000! Even if you bumped your payments down to $500 per month, you would still save $2,700 when compared to your 22% rate.

So let's take a closer look at your options, starting with a secured home equity loan. The great thing about home equity loans is that the rates are excellent when compared to your credit cards. The disadvantage is that not only do you need to own a home, you must have more than 20% equity in that home to qualify. Another way to say this is that you can only borrow up to 80% of your home's value, including your mortgage. Say your home was worth $100K and you have paid your mortgage down to $60K. That means you have 40% equity in your home and would probably qualify for a $20K loan.

Though paying off higher interest rate cards with a lower interest rate home equity loan may seem like a good idea at first, there are a few caveats to consider. First, why do you think you are able to qualify for a lower rate with a home equity loan? Because credit cards are unsecured debt and a home equity loan is a secured debt.

What's the difference? Unsecured debt is debt without collateral: you qualified for your credit card based on your credit history and your signature alone. Secured debt is based on collateral: if you borrow money to buy a car, the car is the collateral and the lender will come after the car if you default on the loan. The same applies with a home equity loan. Unsecured debt is difficult to collect on since there is no collateral securing the debt. This is why credit cards and unsecured debt carry higher interest rates and why secured loans, in general, carry lower interest rates.

Pay off credit cards with a home equity loan, and you just transformed unsecured debt into secured debt and put your home within reach of your creditors. And since most people who get a debt consolidation find themselves in the same amount of credit card debt 3-5 years later, those who aren't careful might find themselves in the same position in the near future without that equity to tap in their home.

The second kind of debt consolidation loans are offered by credit card companies and banks with introductory, low-interest rates. These rates are very attractive for good reason: they are counting on the fact that you won't pay off your debt during the introductory period. Whatever principal balance remains after the introductory period expires is subject to the much higher, non-introductory rate. Make sure you are aware of this rate before you accept any introductory offer.

The beauty of these types of offers is that they are offering money at rates much lower than usual, even when compared to secured debt rates. I have a friend who actually has great credit, accepts these low introductory-rate offers, and then invests the money at a higher rate of return.

How can banks lend at such low introductory rates? Because the non-introductory rate is high enough to make up the difference when the introductory rate expires.

You might be thinking, "I get introductory offers in the mail all the time. Why can't I just keep transferring my balance to a new card with a new introductory rate?" You can, but eventually you will stop receiving those offers in the mail. Though you can save some money in lower interest rates doing the credit card shuffle, it WILL negatively impact your credit score, and eventually you will no longer qualify for those introductory rates. When this happens, you might find yourself with a higher interest rate card than when you started, without the luxury of another introductory rate to switch to. However, all the interest you saved in the interim might just make it worthwhile.

Another option to consider instead of a consolidation loan is a debt waterfall program. The reasoning behind these programs is simple: make your minimum payments on all accounts and take any remaining money you have each month to pay down your account with the highest interest rate. Interest is what makes debt so profitable for banks and expensive for us, the consumer. Interest charged on your accounts reduces your available monthly cash to spend. Therefore, if you begin to eliminate higher interest debt first, you have more money available to pay off your other debt faster. As you go through this process, you accelerate the rate at which you are paying off the same amount of debt, making you debt-free faster. In order to leverage a debt waterfall program, you have to be financially capable of paying more than your minimum monthly payments. If not, a debt waterfall program is out of reach for you.

The pros and cons of loan consolidation are:

  • Pro: Lower interest rates
  • Pro: One check to write each month
  • Pro: Maintain a positive credit rating
  • Con: Secured loans transform unsecured debt into secured debt
  • Con: Can create the false sense that all is okay with your finances, and may encourage additional spending
  • Con: The credit card shuffle (switching from one introductory rate to another) may negatively impact your credit score

 

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