Should I consolidate my debts?

If you own your own home and are burdened by heavy debt, debt consolidation may seem like an ideal solution.

It doesn't take a financial wizard to figure out that combining multiple payments into a single monthly check with lower interest rates can be powerful tool in climbing out from under a mountain of debt, especially high-interest, credit card debt. And for many people, debt consolidation is a great way to go, especially if you consolidate into a home equity loan where the interest is tax-deductible which can be a great financial bonus.

The thing to keep in mind with debt consolidation is that it doesn't reduce your debt... it simply moves it from one place to another, usually from your credit cards to a home equity loan. For many, this is an essential debt management tool in and of itself. Dealing with one monthly bill with a single due date and interest rate can be much easier than managing a fistful of credit card bills with different due dates and varying interest rates with an added benefit of being free of credit card debt for a period of time.

In the best-case scenario, the lower monthly payments provide an avenue for families finally to make headway in their total debt, and they eventually are able to raise their credit scores. When those credit scores rise sufficiently, they can apply for a loan with better interest rates, which can lead to even faster payoff.

However, since debt is only moved and not reduced, if you do consolidate your debt, it's important to keep in mind that it can be only too easy to end up right back where you started with an even greater debt burden. Newly zero credit card balances can be awfully tempting to the people who are likely to get mired in credit card debt in the first place.

If those same consumers don't make a conscious effort to change their ways and pay off their debt, the results can be disastrous. In the worst-case scenario, undisciplined spenders can fall so behind in the payments on their home equity loan that they risk losing their homes. And remember, in all cases, debt consolidation is stretching out the time in which you are paying off your debt, so the interest is piling up.

Keeping that in mind, it is essential to carefully weigh out the benefits and downsides of the different forms of home equity loan relative to your own situation.

Cash-Out Refinancing

First, you can refinance your existing mortgage for a larger amount, essentially "cashing-out" some of your existing equity in your home. If you can secure an interest rate at or close to your existing interest rate, this can make a great deal of financial sense. Instead of a small balance on a mortgage at, say 5.5%, and credit card balances at 19.8%, it could make a lot of sense to refinance everything at 6.0%. You'll have to take a look at your own numbers to see if this makes sense for you.

In addition, if the amount of debt that you need to consolidate is relatively large, your best bet may be a "cash-out refi." The long-term amortization schedule of a mortgage may be the only way to keep monthly payments feasible, and the interest rates tend to be lower than other long-term home equity loans.

Second Mortgages: Home Equity Loans and Lines of Credits (HELOCs)

Home equity loans and lines of credit are other alternatives to a cash-out refi. Often called "second mortgages," these loans are in addition to the original mortgage on your home. If your existing mortgage is locked in at a low interest rate or the amount that you need to borrow is relatively small, it makes much more sense to take out a second mortgage than to refinance your entire mortgage at a much higher interest rate and incur additional closing costs.

In a home equity loan, often called a "term loan," the borrower receives a loan in the form of a lump sum to be paid off over a set period of time in monthly payments with a fixed interest rate. If you know how much you need to borrow and you don't foresee any need to borrow again, a straight home equity loan is probably the way to go.

On the other hand, home equity lines of credit (HELOCs) are revolving lines of credit, which allow a borrower to borrow up to a certain amount for the life of the loan. Somewhat similar to a credit card, the borrower withdraws money as needed from the HELOC at a variable interest rate. As the principle is paid back, the credit revolves and the borrower can use it again until the HELOC expires and everything must be paid off. HELOCs are a good choice when you have an expense that recurs over a period of time because they give you flexibility to borrow only the amount you need when you need it. In addition, if you plan to borrow small amounts that will be repaid quickly, a line of credit can be a more cost effective option than a term loan.

Unsecured Loans and Debt Consolidation Companies

For those who don't own their own home or who otherwise do not qualify for a home equity loan, consumers can explore debt consolidation loans from a bank or other financial institution. Unfortunately, without collateral, the only loans likely to be available will carry a much higher interest rate than a home equity loan, and the interest will not be tax deductible to boot.

In addition, although they the ads may be attractive debt consolidation companies, even so-called "non-profit" debt consolidation companies, should be explored only with great caution. Scam artists populate much of the third party industry that has developed, and in many cases the payments that you make believing they will pay down your debt are actually being funneled into "service fees" and "donations" to the debt consolidation company. And remember, you still owe what you owe, so if your debt consolidation company screws up, it's you that'll land in the hot water.

Even in the best-case scenario where the debt consolidation company negotiates down your payments until your debts are paid, because you are not making payments in accordance with the original agreements, your creditors may still report you as late to the credit bureaus. Although you will get out of debt, your credit will take a very hard hit.

Last Words of Caution

Before you dive into the deep waters of debt consolidation, take some time to consider all your options.

Debt consolidation is a powerful tool not to be taken lightly.

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