Mortgages can be one of the most effective tools for debt consolidation. They can also be one of the most dangerous. Knowing the dos and don'ts of using a mortgage for debt consolidation can make the difference between getting your obligations under control and losing your home.
The following is a look at how you can consolidate debt with a mortgage, followed by some guidelines on when you should and should not consider these strategies.
Should you use a mortgage for debt consolidation?
There are two major reasons why a mortgage is an appealing vehicle for debt consolidation. The first is that mortgage rates are generally much lower than other loan rates.
For example, as of late April 2014, 30-year fixed mortgage rates were at 4.33 percent, according to mortgage finance company Freddie Mac. 15-year and adjustable-rate mortgages had even lower rates. Meanwhile, according to Federal Reserve figures, consumers were paying an average of about 13 percent on credit cards, and about 10 percent on personal loans.
Besides lower interest rates, the other great appeal of mortgages for debt consolidation is that they can stretch repayment periods out over very long periods of time, and thus lower monthly payments.
However, the benefits of mortgages come with a key catch -- the debt is secured by your house. If you fail to meet your payment obligations, you are likely to lose your home. Thus, mortgages should only be used for debt consolidation if it is part of a broader plan to get your budget under control.
Refinance a Mortgage or Use a Home Equity Loan?
To pay off existing debts and consolidate them into a mortgage, you could either get a home equity loan, or you could refinance a mortgage for more than the remaining balance on your existing loan. Either approach depends on you having sufficient equity in your home to borrow against and to provide security to the lender.
As for whether it is better to refinance a mortgage or use a home equity loan, this comes down to rate comparisons - not just between refinance rates and home equity loan rates, but also between refinance rates and your existing mortgage rate. The key here is that refinancing resets the rate on your entire mortgage balance, while a home equity loan just sets the rate on your new borrowing. So, if your existing mortgage rate is much lower than prevailing refinance rates, then you'll want to leave the existing loan in place and add on a home equity loan. However, if refinance rates are cheaper than or comparable to your existing mortgage rate, refinancing may be the more cost-effective way of consolidating debt.
Dos and Don'ts of Debt Consolidation with a Mortgage
While there are benefits to using a mortgage for debt consolidation, it is a serious step that should only be taken after detailed analysis. Here are some of the dos and don'ts involved in this kind of decision:
- Do: Assess the long-term interest cost of any debt reorganization. The downside of spreading payments over a longer period is that it can cost you more interest in the long run. Be sure to look at an amortization schedule before taking out any loan, to see how much interest you will be paying over the long run. You may be able to save a lot of money by refinancing your debt, but then pre-paying it so it doesn't take decades to zero out your balance.
- Don't: Use debt consolidation to facilitate further borrowing. If you simply use a mortgage to take pressure off your credit card limits, and then start building your credit card balances back up, you are heading for big trouble.
- Do: Make sure you have a repayment budget worked out before you take on any new mortgage obligation. This should all be part of a comprehensive plan to get your spending under control and your debt payments within your financial means.
- Don't: Take on a gimmicky mortgage that leaves you with a future balloon payment you can't hope to meet. While that approach may give you smaller payments in the near-term, unless you have a solid reason for expecting to have significantly more money in the future, this approach is really just wishful thinking.
- Do: Shop around and compare home equity and refinance rates. Once you decide whether a home equity loan or refinancing makes better sense for your situation, get quotes from multiple lenders to make sure you are getting the best home equity or refinance rates.
- Don't: Wait until you are behind on payments to take control of your debt situation. If debt is getting hard to manage, you need to act decisively. If you wait till your credit history is a mess, getting a mortgage may no longer be an option.
- Do: Carefully scrutinize any credit counseling agency you work with, especially how they get paid. If you decide to work with a credit counseling agency as part of your debt consolidation approach, be careful - there are a lot of sharks in the water. The National Foundation for Credit Counseling has some common-sense guidelines for choosing a credit counselor.
Getting debt under control is very important, but just remember that using a mortgage to consolidate other debts puts your house at stake. Your house should be viewed as a long-term asset, and should not be put at risk for a temporary solution.