Step 2: Choosing a debt consolidation loan

Now that you know how much debt you are carrying, it’s time to set up a plan to pay it off. A debt consolidation loan can be helpful when trying to eliminate debt, because you have just one loan and one monthly payment to keep track of.

If you’re a homeowner, you can consolidate your debt using your home equity, which will likely give you a lower interest rate on your consolidation loan because the debt is secured by your home. Equity is the part of your home that you actually own. You can build equity two ways:

  • By paying down the principal, or loan amount, on your home.
  • Through appreciation in the value of your home.

When you sell your home, the home equity is the cash that you get after paying off your mortgage. But you can also access that money while still living in your home, for things such as a debt consolidation loan.

Your options
There are several ways to you can access you home equity to pay off debt.

  • Cash-out refinancing. This involves paying off your current mortgage and taking out a new, larger mortgage. You get the difference in cash that you can use to pay off your debt. For example, if you have a $90,000 mortgage on a home that is worth $180,000, you can refinance and get a mortgage for $120,000. You get the difference of $30,000 to pay off your debt. Although your monthly mortgage payment will go up, the interest rate on the debt should be lower, and your overall debt payments (mortgage plus other debt) should be lower.
  • Home equity loan, also known as a second mortgage. A home equity loan is similar to a first mortgage in that you receive a lump sum of money, and the interest and principal payments combine to pay off the loan within a specific number of years. Home equity loans often carry a 15-year term, and usually have a slightly higher interest rate than a first mortgage. Again, the interest rate on your overall debt should be lower than what you are paying now, and your overall debt payments should be lower.
  • Home equity line of credit (HELOC). With a HELOC, you access the equity in your home as needed through a checkbook tied to your loan account. HELOCs have adjustable interest rates and you are charged interest only on the amount you withdraw, rather than the entire credit limit. The line of credit is typically for 10 or 20 years, and then there is a fixed period to pay off the remainder of the loan and interest. The interest rate on a HELOC is generally higher than rates on mortgages and home equity loans.

For a situation in which you need money in one lump sum, such as with consolidating debt, cash-out refinancing or a home equity loan are usually better choices than a HELOC. This is because a first mortgage or home equity loan will likely carry lower interest rates, and the rate can be fixed so you have the security of knowing how much your payments are each month. With a HELOC, you may also be tempted to pay only interest on the loan each month, which does nothing to actually reduce your debt load.

One note of caution with any type of home equity loan – the collateral for the loan is your house. This means if you default on your debt consolidation loan, you can lose your home. Be sure before getting a home equity loan that you can afford the monthly payments. In addition, with all of these options, you reduce the equity in your home until you repay the debt. So, let’s say you bought your house for $200,000 and sell it for $250,000. You also have a home equity loan for $20,000. Instead of having $50,000 of equity at closing, you have only the difference, $30,000. However, all of the debt that you used the home equity loan to consolidate is now paid off.

Personal loans for non-homeowners
If you do not own a home or do not have much equity in your home, you can still get a debt consolidation loan. Instead of a loan backed by your home, you can use a personal loan. A personal loan will usually carry a higher interest rate than a loan using a home to secure it, but the interest rate can still be lower than that of a credit card. If you can lower your interest rate with a personal loan, you should still be able to lower your interest cost and pay off your loans more quickly.

Debt consolidation can be a smart move, as it can help you to plan your way out of debt. In addition, the interest on home equity loans is usually tax deductible, meaning even more savings. (Check with a tax advisor about your situation.) But remember, getting a debt consolidation loan and then continuing to run up credit card debt will put you in a worse situation than before you started. You must couple a debt consolidation loan with discipline in your spending.

Next: Set a timetable to pay off your debt.


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