There are times in most people’s lives when they become burdened with too much debt. They may have a mortgage, car loan, student loans, and credit cards… All of these have monthly payments that eat into the paycheck leaving little left over for all the other bills – groceries, insurance, electricity, living…
And then another catastrophe happens, the car breaks down resulting in a massive repair bill. It appears nothing short of winning the lotto will dig them out of this pit of debt now.
While explaining the situation to their banker, he comes up with what seems to be the answer: a debt consolidation loan (which has its pros and cons). He suggests you take a new loan to pay off the car, the student loan, the credit cards and the car repair bill. You will have just one monthly payment that is significantly less than what you were paying previously.
This sounds too good to be true, and it just might be if they are not careful.
Types of Debt Consolidation Loans
There are four ways in which debt is usually consolidated. These are personal loans, personal lines of credit (LOC), home equity lines of credit (HELOC), and mortgage refinancing.
Loans are given to people all the time. They can be used for personal items such as a car, a vacation, or to pay for medical bills. The repayment terms are negotiable so that the time to pay off the loan and the monthly payment amount can be tailored to meet the borrowers’ needs and ability to pay. Another feature of personal loans is that lump sums, including the full amount, can applied at any time without penalty
Personal Line of Credit
The personal line of credit is an open loan to certain credit limit. The borrower is able to take money from the LOC for any purpose up to a certain limit, e.g. $50,000. The monthly minimum payments will fluctuate depending on the outstanding balance. Like a personal loan, the outstanding balance can be paid out any time.
Home Equity Line Of Credit
The HELOC operates the same as a personal LOC. The difference is that the bank secures the loan with the borrower’s home. This also results in lower interest rates because of the security.
If the borrower’s home has enough equity, the banker may suggest refinancing the property to use some of the home’s equity to pay off the debts that have accumulated. The advantage to mortgage refinancing is the lower interest rates on mortgages compared to other loans.
The Cons of Debt Consolidation
Debt consolidation usually reduces the interest being charged and lowers the monthly payment. But it usually extends the payment period out over a longer time frame. This extension of payments means that a person could ultimately pay more for those items.
The mortgage refinance can be the worst. Consider a car loan for $25,000. Based on 8% interest on a five year loan, the monthly payment will be $506. If no lump sum payments are involved, the car will cost $30,400 of which $5,400 will be interest. Compare that to a mortgage refinancing, the terms are 5% over twenty-five years. The final cost of the $25,000 car will be $43,800 of which $18,800 is interest! Will the car even last that long?
The second pitfall has to do with personal attitudes and emotions. It happens far too often that the borrowers do not change their lifestyles. Once the debt has been consolidated into a single and affordable payment, they become complacent about their spending. Sometime in the future, they find themselves in the same situation where credit cards are at their limits, and a new car has been purchased. Equity in the home is used like a personal ATM cash machine. They once again refinance the home to pay off these new debts while the old debts are still not paid off. Now how much is the first car going to cost? Refinancing charges have not been mentioned but they will be applied to further compound the payments.
Debt is a normal part of most young adults’ lives. And there are times when debt consolidation makes sense. It makes sense to replace high interest debt (credit cards) with lower interest debt, and to reduce monthly payments without extending the term to pay back. The goal is to repay the debt as quickly as possible.
The best way to consolidate debt is the HELOC because of the lower interest rates charged and the pre-payment options. A personal LOC or personal loan is preferred over the mortgage refinance.
Once the method of consolidation is chosen, a plan is needed. The plan is to pay more than the monthly minimums and to add lump sum payments to accelerate the pay down of the loan and to reduce interest costs. The second part of the plan is about the borrowers, their attitudes and emotions; the commitment and the discipline to follow the debt repayment plan is needed. And more importantly, they need the commitment and the discipline to live within their means.