A debt consolidation loan can be a useful way to combine your debts and save money if you are paying off high-interest rate debt. By consolidating your debts into a loan with a lower interest rate, you can get great financial benefits.
Done right, taking out a debt consolidation loan can be a smart move. It can help you move your way out of debt. In addition, if you use a home equity loan or line of credit, the interest on a debt consolidation loan is usually tax deductible. (Be sure to check with your tax advisor.) Instead of having several credit card balances, you can combine them into one payment. Be careful, though. If you do take out a debt consolidation loan, and then continue to run up credit card debt, you will be even worse off than you were before.
Using home equity for debt consolidation
You have several choices when it comes to debt consolidation. One option is to use your home equity. The equity is the part of your home that you actually own. You can build it up in two ways -- through paying more to the principal or through the appreciation of the home. When you sell your home, the home equity is the cash that you get after paying off your mortgage. By getting a home equity loan, you can access that cash while still living in your home.
There are two types of home equity loans that can be used for debt consolidation.
1. Home Equity Loan. A home equity loan is similar to a first mortgage in that you receive a lump sum, and the interest and principal payments combine to pay off the loan within a specific number of years. Home equity loans generally have a 15-year term and usually carry a higher interest than a first mortgage.
2. Home Equity Line of Credit. Another option is a home equity line of credit (HELOC). In this case, you access the money as needed through a credit card, checkbook, or debit card tied to that loan. HELOCs have adjustable interest rates, and you pay interest only on the amount you withdraw rather than on the entire credit limit. The line of credit is typically extended for 10 or 20 years, but after that, there is a fixed period in which you must pay off the remainder of the loan and interest.
If you have a one-time purpose for the money, such as consolidating debt, a home equity loan is usually the better choice. They are also easier to budget than a HELOC, since home equity loans come with a fixed interest rate.
When you use either type of loan, 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 $220,000. The equity in the house would be $20,000. But, if you have taken out a home equity loan for $10,000, you won’t be able to keep the entire $20,000 of equity at closing. You would only keep the difference: $10,000. However, all of the debt that was consolidated into the home equity loan is now paid off.
Keep in mind that, with any type of home equity loan, the collateral is the house. That means that if you default on your debt consolidation loan, you can lose your home. Before getting a home equity loan, be very sure that you can afford the monthly payments.
Personal loans can also help consolidate debt
If you decide a home equity loan is not for you, or perhaps you do not own a home, there is another option for debt consolidation. You can get a personal loan with a lower interest rate than what is on your credit cards. You can still consolidate all of your debts into one loan with a lower interest rate without using home equity. The rates will not be quite as good, though, as they are when a house secures the debt.