The many faces of debt consolidation
Debt consolidation explained
- Debt consolidation combines several debts into a single debt, typically with a better rate.
- Two common forms of debt consolidation are balance transfers and personal loans.
- Other options for consolidating debt is to use the equity in your home, with a cash-out refinance or home equity lines of credit.
People often run up debts on several credit cards, a situation that can be hard to manage.
These debts may carry high rates of interest, and varying payment dates. You can miss payments, which can mess up your credit score. With so many bills coming in, you may find it next to impossible to pay down that debt.
So, like many people, you may find it convenient to consolidate these bills with a single loan.
Balance transfers and loans
One of the most common forms of debt consolidation is a simple balance transfer. Credit card companies commonly try to get their customers to transfer the balance of other cards. Typically, they offer a teaser rate at no or low interest for a set period.
One of the upsides of balance transfers for the borrower is that the process tends to be easily accomplished, with little paperwork or waiting. The downside is that the teaser rates will almost always end, and you could be left with a large balance on a high-interest adjustable rate credit card. There also is the danger of racking up additional debt on this card, and other credit cards, putting you in worse financial shape.
A debt-consolidation loan is another route to take, and it can take various forms. Most banks and credit unions offer personal loans, many of which are specifically marketed as debt-consolidation loans. Personal loans can either be secured by your property, or unsecured. Both kinds have their advantages.
Unsecured loans usually carry higher interest rates, but won’t put your property at risk should you default on the loan. Secured loans take the property as collateral. The lender can go after that property should you default on the loan.
In some cases, a debt-consolidation loan is nothing more than a cash-out refinance on the primary home mortgage. As home values have risen, more and more homeowners have built up equity in their homes. Much of that value can be tapped by refinancing the initial loan and cashing out some of the value.
Borrowers with high-debt loads, particularly credit card debt, can use that money to clear those debts. Typically, the borrower can secure a long-term fixed-rate mortgage at a much lower rate than they would with a credit card or personal loan.
In recent years, however, homeowners have been able to lock in 30-year fixed-rate mortgages with historically low rates. Rather than cashing out the equity in that loan, it may make more sense to take out a second loan or a line of credit.
Home equity borrowing
A home equity line of credit, often called a HELOC, functions like a revolving credit line. There is draw period, where the borrower can take out money and only pays interest on the drawn amount. After the draw period ends, which can last up to 20 years, the borrower can no longer draw on the line and must pay back both interest and principal over a repayment period that typically lasts 10 to 20 years. HELOCs are usually adjustable, meaning the interest rate on the drawn amount will change over time.
Home equity loans, by contrast, are second mortgages, where the borrower will receive a lump sum and begin to pay down the interest and principal almost immediately. Home equity loans can be either adjustable- or fixed-rate.
Home equity loans usually carry much lower interest rates than standard credit cards. There are, however, disadvantages. As secured loans, you can put your property at risk in the event that you default.
The bottom line is that borrowers have a lot of debt-consolidation options. The right choice will often depend on the size of the debt and the fees associated with the loans. Borrowers should shop around before committing to a specific product.