What is debt consolidation?
Debt consolidation definition:
The practice of eliminating multiple debt payments by obtaining a new loan with a single monthly payment to pay off existing accounts.
How does debt consolidation work?
The concept of consolidating debt is simple. Accumulating credit card, department store, and other revolving debt is common. Difficulty paying it off is equally as common. The high interest rates and low minimum payments typically associated with credit cards make eliminating those balances frustrating. By pooling that debt into a new loan with a single monthly payment, the debt becomes manageable, with a defined monthly payment and termination date.
Oftentimes, when consolidating debt, the loans and credit cards being paid off have higher interest rates than the consolidation loan. Credit card interest rates can be as much as 30% or more.
Types of Debt Consolidation
There are four common types of debt consolidation.
- Credit card balance transfers
- Personal loan
- Home equity loan
- Mortgage refinance
Credit Card Balance Transfers
We aren’t going to touch much on consolidating into one credit card because it rarely works. Rolling your card balances onto one credit card can work, especially if the balance transfer rate is 0%. However, it’s still a credit card, and if you aren’t careful, you can find yourself right back where you started, with a high credit card balance at a high interest rate.
Personal Loan Debt Consolidation
Consolidating higher interest credit cards, department store cards, and other loans into a personal loan is likely the easiest path to debt consolidation and ultimately, debt elimination.
A personal loan is usually a fixed rate, meaning the rate does not fluctuate, loan with payments spread out over several years. Obtaining a personal loan is quicker than most options because there is no collateral needed to secure the loan. Collateral is an asset used as backing for the loan. If a borrower defaults on a collateralized loan, the bank can repossess the collateral, such as a car, boat, or other tangible asset.
Personal loans are unsecured, which means the lender or bank is using your credit profile to determine your worthiness. Since there is no asset for the bank to repossess to become whole, consolidation personal loans typically require a combination of strong employment, income, and credit history. If you meet the criteria, personal loans can fund and have your debt consolidated in as little as a day or two.
Interest rates and terms for personal loans can vary greatly depending on how much you borrow and for how long you spread out the payments. Terms can range from six months to 84 months or longer. The longer the term the lower the payment, assuming the interest rate is constant. Interest rates are determined by the strength of your application and credit profile. A general rule is the higher your credit scores the lower the interest rate. Some personal loans have rates in the low single digits, while others can be 24% or more.
Personal loans are a great way to consolidate debt into one monthly payment with an established payoff date. They are often the path of least resistance when considering how to consolidate credit cards and become debt free.
Home Equity Loan Debt Consolidation
What is a home equity loan?
Home equity loans use the equity in your home as collateral to secure your loan. If your home is worth $250,000 and you have a $200,000 mortgage, you have $50,000 in equity.
Banks let homeowners “tap into your home’s equity” by issuing a loan and filing a second mortgage against your home. Every bank is different, but some will allow your combined loan-to-value (CLTV) to equal 100% of the appraised value of your home. However, many banks cap the CLTV at 90%. Start with your primary bank and shop around from there to find home equity loan terms that work for you.
Using your home’s equity to consolidate debt has a few advantages. Home equity interest rates are often lower than comparable personal loans. Additionally, if you have the equity, it may be easier to be approved for larger loan amounts considering the bank is securing the loan with your home and not just your signature.
Using a home equity loan to consolidate debt can take considerably longer than obtaining a personal loan. In some cases, the bank may use your county’s assessed value to determine your home’s equity. However, if that value is not sufficient, you may have to wait for a full home appraisal to be completed, which may take a few weeks and could cost you $400-$500. If you’re confident in the amount of equity your home has and can afford to wait a few weeks before the transaction is complete, a home equity loan may save you considerably in the long run and provide more substantial funding than an unsecured personal loan.
Mortgage Refinance Debt Consolidation
The final, most labor-intensive option is to refinance your mortgage and use the equity in your home to consolidate your other debt. This option is similar to a home equity loan. However, instead of having two mortgages, you’ll be paying off your existing mortgage along with the debt you are consolidating.
Consolidating debt with a mortgage refinance has its hurdles. First, mortgage lenders call this a “cash-out refinance” because you are “cashing out” your home’s equity. Cash-out refinance loans are considered riskier mortgage loans than traditional rate/term refinance or home purchase loans. The loan-to-value (LTV) restrictions on cash-out refinance mortgage loans often eliminate it as an option right away.
If you are a veteran or active military, VA loans permit cash-out refinance loans up to 100% of the value of the home.
If you have the equity necessary to obtain a cash-out refinance, the advantages are undeniable. There can be tax benefits in addition to the historically low interest rates currently offered by mortgage lenders. Having only one payment can have a tremendous effect on monthly cash flow, giving your more money to save or allocate towards more important things than paying off credit cards.
Mortgage rates are so low and the industry so competitive, that some lenders will cover your closing costs as incentive to do business with them. Making a mortgage refinance debt consolidation loan even more desirable. If you can check all the boxes, refinancing your mortgage to pay off debt can save you thousands of dollars over time, in addition to simplifying your debt into one manageable monthly payment.