Our financial situation has changed drastically in the past couple of years, and even after scraping up every last penny, we’ve gotten to the point where we can no longer make all of our monthly payments. We have been looking at out options, but are pretty confused. Can you explain to me how debt consolidation works? – Carol, Florida
Debt Consolidation is a process where you roll all or some of your debts into a single loan, preferably at a lower interest rate than the ones you’re paying now. This idea is good in theory, and in some cases in practice. But there are also predators in the industry who will charge you thousands of dollars and pressure you into making a decision that’s not in your best interest. Instead of giving them your business, try to consolidate yourself using a Home Equity Loan or Line of Credit (HELOC), by refinancing your mortgage, or taking out a personal loan at a lower interest rate. Then take the new, cheaper loan, and use it to pay off credit cards, car loans, student loans, and other debts that have higher interest rates. All in all, you’ll cut your monthly outlay — perhaps substantially.
Here’s what you need to know about the various loans.
Home Equity Loan. A fixed-rate loan, where you can take out money in one large chunk, and then begin paying it back immediately. However, says Greg McBride of BankRate.com, “it can be hard to qualify without substantial equity as most lenders want borrower to retain 20%-30% equity after the loan.” You should shop around for this kind of loan – at both big and small banks, as well as online lenders – though often, many of the best rates come from credit unions. Check bankrate.com for the most up-to-date information. Right now, for a $50,000 home equity loan for a person in your state with good credit (660-749), the interest rate is 8.14%. At those rates, the monthly payment (assuming a 10-year term) is about $610.
Home Equity Line of Credit (HELOC). A variable-rate loan, often tied to the prime rate. This means that if interest rates rise, so will your monthly payments. Taking out a HELOC means that you can withdraw money as you need it, rather than getting it all at once. You pay back the money you take out, and are only charged interest on the money you use. Like Home Equity Loans, they can be difficult to qualify for without substantial equity in your home. Again, you should shop around for the best interest rates – right now the rate on a $50,000 HELOC again in Florida for a person with good credit is 5.49% which translates in to a $542 monthly payment. Watch out for rising interest rates, says McBride. “When the Federal Reserve eventually begins raising interest rates, HELOC rates will march steadily higher, taking what might be 4.5% today to 6.5% or 7.5%.” At 7.5% your monthly payments could hit $593.
Cash-Out Refinance. A loan that allows you to refinance your mortgage and, at the same time, draw out some of the equity in your home. The amount you can draw out is either a portion of what you’ve paid in, or what has become yours through appreciation (which has gotten tougher in recent years). It’s not a second mortgage, but it instead replaces your current mortgage. (One advantage HELOCs and Home Equity Loans have over Cash Out Refis — no closing costs.) Right now, it’s possible to find a 30-year-fixed rate mortgage with an interest rate of 4.5%. That’s lower than on Home Equity loans and lines. But you have to consider whether you’ll make up the cost of doing the deal in the amount of time you’re planning on living in the home.
Lastly, before you consolidate — particularly rolling credit card debt into any form of home equity — you have to keep in mind that you’re taking an unsecured debt (one where, if you default, you’ll only see a hit on your credit score), and turning it into a secure debt (where defaulting means they can take the asset associated with the loan). That means being sure you’ll have the fortitude to keep your credit cards clear after the consolidation. If you start charging with abandon once again just because you can, you’ll sink your financial future even further.