Why Not Do-It-Yourself Debt Consolidation?

Mention the term "debt consolidation" and a lot of people think in terms of programs and lower monthly costs.

The idea of debt consolidation is to gather debts from various places and refinance them with a single loan so they can be repaid with a lower -- and more tolerable monthly cost.

There are some cases where debt consolidation makes sense. For instance, imagine that you have $20,000 in credit card bills with an annual interest rate of 13.14 percent -- that's the actual rate paid out by borrowers in February according to the Federal Reserve. If we want to pay off this debt in five years -- it's less than the cost of many new cars -- then the monthly bill would be $456.50.

One way to lower the cost of this debt would be to have a seven-year pay-off. Now the monthly cost falls to $365.36.

The catch is that while the monthly expense has declined the actual interest cost grows from $7,390 over five years to $10,691 over seven years. That's a huge interest increase to save less than $100 a month.

Debt Consolidation and HELOCs

Another approach would be to refinance the debt with a home equity line of credit or HELOC. The attractions here are two-fold: First, the rate of interest might be around 8.25 percent as this is written for an individual with good credit, say between 640 and 750, a big reduction. Second, because the debt is secured by real estate, it's likely that the interest is tax deductible -- see a tax professional for details.

If we refinance $20,000 at 8.25 percent over five years the monthly cost will be $408 a month, but the overall interest cost will fall to $4,475. In addition, if we're in the 25 percent tax bracket, then our tax bill can fall by $1,119 over five years.

Of course, for those with excellent credit -- a score above 750 or so -- the interest rate could be substantially lower, say 4.5 percent in some cases. Now we're talking about a monthly cost of $371 and a total interest expense over five years of just $2,235.

So far it would seem that a do-it-yourself debt consolidation with a home equity line of credit can be really attractive; however, there's a hidden issue which needs to be discussed: It makes no sense to engage in a debt consolidation program by yourself or with a program if tomorrow you go out and rack up more debt.

Debt Consolidation and Budgets

To some degree, Americans have gotten the message. In February the total amount of revolving debt -- typically credit card balances -- stood at $854 billion. That's a lot of money but it's less than $917 billion outstanding in 2009.

The catch is that while Americans have been reducing credit card obligations, they've been increasing other forms of consumer borrowing. Non-revolving debt such as loans for mobile homes, education, boats, trailers and vacations now totals $2.275 trillion -- up substantially from the $1.636 trillion owed in 2009.

So here's the deal: Debt is a financial tool. Use it wisely. If you want to consolidate debt shop around for the best options. But don't stop there: Make a budget, stick to it, reduce overall debts and save. Your credit score will go up, the cost of borrowing will go down, your debts will fall and your monthly costs will decline.

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