Guide To Lenders
April 17, 2014

Top Seven Debt Consolidation Considerations

Gary R. Crum

Debt consolidation loans are a tried-and-true way to get your finances under control. You can lower your interest rate and monthly payments while wrapping up several payments into one. By using this smart way to tap into your home equity you can save yourself money and maybe even get a tax deduction for the interest you pay.

1. Debt consolidation with a mortgage offers lower rates.  Debt consolidation can be achieved by refinancing a first mortgage and taking additional cash out, or by tapping home equity with a second mortgage. Because debt consolidation loans are typically secured your house, the loan is less risky than other types of debt and the interest rates are lower. It also means you are putting your house at risk if you don’t make the payments. Do not sign up for a debt consolidation loan unless you are certain you will be able to make the payments. It's better to not pay your credit cards than to lose your house.

2. Interest may be tax deductible. In many cases interest on a debt consolidation loan is tax deductible.

  • The combined loan amount of your first mortgage and your debt consolidation loan cannot exceed 100% of the value of the house.
  • The IRS does limit your home equity deduction to interest on a loan amount of $100,000 unless it's for home improvement.
  • To take advantage of this benefit, you need to itemize your deductions on a Schedule A.

3. You have the option of selecting revolving line of credit. A line of credit can be used to consolidate debt while keeping any unused balance available for future emergencies or needs like college tuition. All home equity lines of credit (HELOCS) used for debt consolidation loans come with adjustable rates so there are risks of payment increases with this type of loan. However, most of these loans allow you to fix the rate at one or more times during the life of the loan. The risk of rate increases may be offset by the extra flexibility HELOCs offer. 

4. You can choose a fixed rate loan. Consumer advocates often recommend a fixed rate loan for debt consolidation. First, you know what the payments are going to be, making budgeting easier and lessening the chance that you will get into trouble with too much debt again. Second, it is like your fixed rate first mortgage and will be paid off over fifteen or twenty years. Finally, credit card rates can be raised any time, for virtually any reason, and there additional fees imposed as well. With debt consolidation loans, especially fixed rate ones, you don't have to worry about bait-and-switch tactics.

5. It may be your best source of funds for home improvement. You may have run up credit card debt for home improvements. It especially makes sense to use a consolidation loan here because the debt is associated with increasing the value of the house and you will be able to realize significant savings over credit card interest rates.

6. Choosing the best loan for debt consolidation involves a little homework. Debt consolidation can be achieved by refinancing a current mortgage and taking out extra cash to pay off bills. This is sensible if the existing mortgage can be improved on and the savings will be enough to recoup the cost of refinancing. Second mortgages cost little or nothing to originate and usually involve smaller amounts, so even though they carry higher rates than first mortgages it may make more sense to consolidate debt with a second mortgage and leave a good first mortgage alone. Comparing the combined rate of an old 1st and a new 2nd  with that of a new first mortgage is easy.

For example, a borrower has a $100,000 first mortgage at 5.5% and needs to borrow another $10,000 to pay bills. He could get a new $110,000 loan at 6%, or keep the current loan and get a $10,000 second mortgage at 10%. Here's how to find the better deal:

            Take the 1st mortgage amount times the interest rate: $100,000 * 5.5% = $5000

            Take the 2nd mortgage amt times the interest rate: $10,000 * 10% = $1000

            Divide the $6,000 total by the $110,000 combined amount of both mortgages

The result is 5.45%, which is lower than the 6% rate for a new first mortgage. The second mortgage is the better deal.

7. Debt consolidation loans come with pitfalls:

  • Unlike credit cards, debt consolidation loans are liens against your home and if you don’t make the payments you can lose it in foreclosure.
  • Adjustable rate loans can become unaffordable if interest rates go up.
  • Interest-only adjustable rate loans are the riskiest of all loans since you are not reducing the principal balance.
  • If you run credit card debt after debt consolidation you will have higher payments than before and no way to consolidate debt. Consumer advocates recommend that you cut up all your credit cards except one for emergency use.

Debt consolidation makes sense for many consumers, and there are plenty of options for trimming your debt costs and making your payments more manageable. Taking on a new loan with your eyes open can be the smartest thing you do to bring your finances in line.



 Federal Reserve Bank: Do you want to consolidate your debts?

Consumer Reports: What if your debt has gotten out of control?


About the Author:

Gary Crum is a nationally published writer of consumer finance articles and writes a frequently for banking and credit union publications. He has worked in the banking and mortgage business for over 30 years. Gary holds an undergraduate degree from Florida State University and he earned an MBA from Florida Atlantic University
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