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Many people consider consolidating debt as a step in the process to eliminate debt. Debt consolidation is a viable option, but you need to understand what you’re getting yourself into. Before taking on a debt consolidation loan, make sure you understand the big picture.
So What Is Debt Consolidation?
Debt consolidation in the simplest form is taking out a big loan to pay off smaller loans. There are essentially three ways to do this:
- Home Equity Loan/Home Equity Line of Credit/Cash Out Mortgage
- Personal Line of Credit
- Credit Card Cash Advance/Credit Card Balance Transfer
Each of these methods has pros and cons. So, let’s discuss the differences between these options.
Home Equity Loan/Home Equity Line of Credit/Cash Out Mortgage
There are numerous names for these types of loans, but at the basic level they’re all mortgages against your house. With each of these mortgages, some of the equity is taken out of your house in order to pay off other debt. In some cases, the original mortgage is rolled into the new loan, in other cases, the new loan takes a second position after the existing debt.
The positive part of consolidating your debt using a mortgage based consolidation is that the interest is probably tax deductible (depending on your specific situation). However, there are several downsides to this type of debt consolidation method. First, you have to have good credit. Second, you have to have enough equity in your home to borrow against (and who has that nowadays?).
But, the biggest issue with this type of consolidation lies in the difference between secured and unsecured debt. Unsecured debt is debt that doesn’t have something that the bank can repossess to pay off the debt (think credit cards). Secured debt is debt that is secured by a physical asset that the bank holds a lien on until the debt is paid off (typically, mortgages and car loans). Because of this “security,” secured debt is typically held at a much lower interest rate than unsecured debt. Sounds pretty good, right?
What happens if you don’t pay your credit card bill? You mess up your credit and get a bunch of angry phone calls. What happens if you don’t pay your car loan? You wake up one morning and your car is gone. And if you don’t pay your mortgage, they come throw you out on the street. So, do you really want to pay off unsecured debt by putting your house at risk?
Personal Line of Credit
In order to get a personal line of credit (i.e. personal loan), you need excellent credit. However, even with excellent credit, odds are that you’re going to get hit with a fairly high interest rate (which is likely to be variable). The downside here is that you’re likely to increase the interest rate that you’re paying.
Credit Card Cash Advance/Credit Card Balance Transfer
Consolidating your debt by rolling it onto a new credit card can make sense in some cases, especially when you get a very low interest rate (such as a temporary rate of 0%). You just need to make sure that you’ll be able to pay it off before the temporary rate expires or you might find yourself looking at a worse situation than you started with. In addition, opening a new account will affect your credit score, most likely in a negative way.
Final thoughts
When you’re considering debt consolidation, make sure you understand the long term impact of your decisions. If you’re unsure, feel free to post your question on the get me out of debt forum.
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