Pros and Cons of Debt Consolidation Solutions
After reviewing the terms of your accounts, and using a debt consolidation calculator, you’ve decided that debt consolidation is a good solution for you. Your next step, then, is to choose a method for consolidating and paying off your debts. The four most often-used strategies are balance transfers, personal loans, cash-out refinancing and home equity loans. Here’s a quick rundown of the pros and cons of each method.
Cash-out refinancing means replacing your current mortgage with a larger mortgage and taking the difference in cash. This can be used to consolidate debt or for almost any other purpose.
- Because the loan is secured by your home, the interest rate is much lower than that of debt like credit card balances. Average cash-out refinance rates in late 2013 are about five percent.
- The interest may be tax deductible (check with a tax pro).
- You can lower your monthly payment significantly, because home mortgages can have much longer terms. Stretching out your credit card debt with a ten- to thirty-year loan really lowers drops your payment.
- You can a better rate than that of your old mortgage.
- The loan is secured by your home, so if you can’t make the payment, you could end up in foreclosure.
- Credit card debt can be discharged in a bankruptcy because it’s unsecured. Once that debt is secured by a home, you can’t discharge it with a Chapter 7 filing.
- Cash-out refinances take time. There’s an application, an appraisal, a title search, etc.
- Cash-out refinancing has higher upfront costs than any other strategy. It’s a good solution only if the new loan has better terms than the mortgage it replaces.
- Stretching out your repayment can increase your total interest expense, even if the interest rate is lower. This can be prevented by making extra principal payments to lower your balance.
Home Equity Loans
Home equity loans and home equity lines of credit (HELOCs) are also called second mortgages. Like cash-out refinancing, they let you trade home equity for cash, which can be used to consolidate your debts. Home equity loans can carry fixed or variable rates. Fixed rates, however, make budgeting easier. Home equity terms range between five and 25 years, with the average being 15 years.
- Because the loan is secured by your property, the interest rate is lower. Average home equity loan rates in late 2013 were about seven percent.
- The interest is likely to be tax deductible. Check with a financial advisor.
- Replacing multiple accounts with variable rates, like credit cards, with a single fixed rate loan makes managing debt much easier.
- Home equity loans have much lower costs than cash-out refinances and can be processed much more quickly.
- Stretching out your debt repayment over more years can substantially lower your payment.
- Like cash-out refinancing, a home equity loan increases the amount of debt secured by your home. Should you find yourself unable to make the payment, you could end up in foreclosure.
- Debt moved from unsecured accounts to a mortgage (which is what home equity debt is) can no longer be discharged in bankruptcy. If your finances are shaky, a mortgage is probably not your safest choice.
- Stretching out your debt over a longer timeframe may increase the total interest cost, even if the interest rate is lower. This can be avoided by accelerating your repayment with extra principal payments.
Also called signature loans or unsecured loans, debt consolidation should be to get debt-free more quickly and / or at a lower cost. And so the one big con of all methods is that people without the discipline to stick to their debt repayment program may run their cards back up. Then they have their debt consolidation loan plus all their credit card balances. Experts estimate that this happens to between 50 and 85 percent of people who try debt consolidation. Make sure you aren’t in that camp before trying any of these methods.