Replacing several debts or loans by transferring the balances to a single loan or line of credit, usually at a better rate. (Debt consolidation loans are often home equity loans or lines.)
When paying off debt to several different lenders, the interest can really add up. If you owe credit cards, car payments, and a mortgage, you know that each has a different interest rate and that the mortgage tends to have the best rate. Consolidating debt using your home to secure the loan can get you a better interest rate to pay off your debt.
For example, say you owe $50,000 in credit card debt. The interest rate attached to the cards is 18 percent. However, you can refinance your house and get a 6 percent interest rate and consolidate the debt into your mortgage.
The way this works is simple. Talk with your lender and explain that you want cash-out refinancing. That means that you are taking out a new mortgage with a larger principal than your current mortgage. If you owe $50,000 in credit card debt, your new mortgage will be that much more than your current one. The lender then gives you the $50,000 that you use to pay off the credit cards. Now, you repay the mortgage company, but at a fraction of the credit card’s interest rate.
Consolidating debt through refinancing may not be for everyone. Whenever you default on a loan, there are serious consequences, but if you are negligent in repaying a mortgage, you run the risk of losing your house. That is because the loan is secured against your home. That guarantees you a lower interest rate, but raises the stakes of the importance of repaying your loan. Therefore, it is vital to discipline your spending if you are consolidating debt. It does no good to pay off the $50,000 then immediately get more credit card debt.
If, however, you can be disciplined with your spending, consolidating debt with a new mortgage can be a great option. The interest on the loan can be tax deductible, unlike with credit card debt. Be sure to discuss this with your tax advisor. In addition to the tax advantage and lower interest rate, you also have the simplicity of rolling all or most of your debts into one loan for one simple payment.