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Debt Consolidation

Debt consolidation is a process by which several debts are replaced by one debt. The idea is to simplify repayment and hopefully make it more affordable as well.

Debt consolidation is a process by which several debts are replaced by one debt. The idea is to simplify repayment and hopefully make it more affordable as well.

Debt consolidation can be a very useful tool if you are paying too much in high interest rates on other debts.  By consolidating these debts through a debt consolidation loan with a low interest rate, you can get great financial benefits.

Debt consolidation can be a smart move.  It can be a valuable tool to help you get out of debt.  Also, the interest on a debt consolidation loan is usually tax deductible if you use a home equity loan or line of credit.  Instead of having several credit card balances, you can combine them in a debt consolidation loan.  However, if you do this but continue to run up your credit card debt, you have put yourself in a worse situation.

Home Equity or HELOC for Debt Consolidation

A good option for debt consolidation 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.  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 to use for debt consolidation – home equity loans and home equity lines of credit (HELOC).  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 are usually for a 15 year term and usually carry a higher interest than a first mortgage.

Another option is a 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 instead of the entire credit limit.  The line of credit is typically for 10 or 20 years followed by a fixed period to pay off the remainder of the loan and interest.

If you need the money for a one-time purchase or use, such as consolidating debt, a home equity loan is usually the better choice.  Also, since home equity loans come with a fixed interest rate, it can make it easier to budget.  However, with the home equity loan (and the HELOC, too), 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 $250,000.  You also have a home equity loan for $20,000.  Instead of having $50,000 of equity at closing, you only have the difference, $30,000.  However, all of the debt that you used the home equity loan to consolidate is now paid off.

One note of caution with any type of home equity loan – the collateral is the house.  That means if for some reason you default on the loan, you can lose your home.  Be very sure before getting a home equity loan that you can afford the monthly payments.

Other Methods

Debt consolidation can be accomplished in different ways. Some of the most popular are:

  • Balance transfer credit cards. These are credit cards with low or no interest for a period of six-to-eighteen months. Borrowers can use them to pay off other accounts and then work to pay off the balance transfer account as quickly as possible.
  • Personal loans. Personal loans can often have lower interest rates and better terms than credit cards and other revolving accounts. Because they have finite terms, replacing credit card debt with a personal loan may be a better way to become debt-free – as long as the borrower does not run up the balances again.
  • Home equity loans. Because home equity loans are secured by real estate, they are safer for lenders and therefor carry lower interest rates. Interest for home equity loans may also be tax-deductible (consumers should check with a tax professional). Replacing higher interest revolving accounts with a home equity loan can lower payments and the amount of interest paid.
  • Home equity line of credit. A HELOC is great when you’re not sure how much money you’ll need, or you need to take out funds periodically instead of all at once.
  • Debt management plans (DMPs). These are offered by credit counseling services. Consumers pay one amount into the plan, and it is distributed among the creditors. Often, credit counselors can get penalties waived and payments reduced to an amount the borrower can afford.
  • Chapter 13 bankruptcy. This is a court-ordered debt management plan. Unlike plans run by credit counselors, creditors cannot opt out of a Chapter 13 plan. A bankruptcy Trustee determines how much the debtor can afford to pay each month. The debtor delivers a cashier’s check each month to the Trustee, who divides it among the creditors. After a three-to-five year period, any remaining balances are discharged.

Debt consolidation takes many forms, from DIY strategies to court-ordered plans. To be successful, however, the borrower must learn to manage debt better and avoid repeating the same overspending patterns.