What is Debt Consolidation?
Debt consolidation is the term used to describe the process where you combine several debt accounts into a single account. A common example of debt consolidation is using a home equity loan to pay off several credit cards.
As the famous U.S. economist Milton Friedman once said, “There is no free lunch.” And when it comes to getting out of debt, his sage advice couldn’t be more helpful.
There is no easy way to get out of debt. One of the greatest myths about debt consolidation is that it eliminates debt. That statement couldn’t be any farther from the truth.
Debt consolidation does not eliminate debt. Rather, it restructures it on more favorable terms. While using a home equity line of credit ito pay off your credit cards n the most technical sense eliminates credit card debt, it does not reduce the amount of money you owe.
Debt consolidation can be a useful tool for lowering your overall interest rate. Debt consolidation often allows you to comibne a number of high-interest loans into one large low-interest loan. (If you’ve read our 5 Step Guide to Getting out of Debt, you know that one of the most important steps in getting out of debt is lowering your overall interest rate.)
Debt consolidation does not require that you open a second mortgage against your home. You can implement debt consolidation with credit cards by transferring a balance from a high- to low-interest rate credit card. Transferring your balance to a low-interest rate card is smart financial planning.
The problem with debt consolidation through home equity loans is three-fold. First, it shifts your debt from unsecured credit cards to debt against your home. While using your home as collateral reduces your interest rate, it also places you in a more precarious situation should you encounter financial difficulties. If you can’t pay a credit card bill, the credit card company can sue you. If you can’t pay a home equity loan, the bank can take away your house. Second, debt consolidation through home equity loans gives a false sense of financial health, and may encourage you to take on additional debt. Third, debt consolidation may increase the total amount of interest you pay. Although your interest rate and monthly payments may be lower, the extended duration of the low — sometimes as much as 20 years — means that you pay more interest in the long run.
Debt consolidation through home equity loans has some tax advantages that unsecured credit card debt does not. The IRS allows you to deduct the interest paid on second-mortgage debt consolidation loans, provided that the total loan amount does exceed the fair market value of your home.
Consider your options carefully. The best situation is to pay off your debts as quickly as possible and with as little interest as possible. We believe consumers should consider a debt consolidation loan as a last resort when unable to meet the monthly payments of their credit cards. We recommend that you consult with an expert financial planner if you are considering a debt consolidation loan.
As always, if you open a home equity loan or line of credit for debt consolidation, we recommend that you comparison shop for the best terms. 4LowRates has an excellent service for providing free debt consolidation quotes.
