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Your Debt Consolidation questions are answered here. Browse around to find new tips and advice from our helpful list of FAQ's from people like yourself.
Q: Can I consolidate my bills with a consolidation loan or a home equity line of credit?
A: Yes you can. However, you need to be cautious when consolidating "unsecured" debts, like credit cards, into "secured" debts, which both home equity loans and home equity lines of credit qualify as.
First, you need to understand the difference between a home equity loan and a home equity line of credit. It's quite simple, actually. A home equity loan is exactly what it sounds like -- it's a secured loan against the equity of your home. For example, if you owned a home worth $250,000 and you owed only $125,000 on it, you would be eligible for a home equity loan for as much as $125,000. If you applied for and received such a loan, you would actually receive a check for $125,000 (less any fees).
A home equity line of credit (HELOC) isn't really a loan -- it's more like a credit card. Given the same case as above, you wouldn't receive a check for $125k, but a "line of credit" equal to that. The advantage here is that you are only paying monthly interest and principal charges on the amount you spend from your line of credit, not the full $125,000.
Regardless, the danger here is that if you're unable to pay your home equity loan payments or your HELOC, your house is in danger. Home equity loans, after all, are commonly referred to as "second mortgages," and just like if you don't pay on your first, your home can be repossessed and sold by your lender. The same applies for HELOCs.
Therefore, it is somewhat risky to consolidate $50,000 of credit card debt into a home equity loan or HELOC. As credit card debt, the debt is "unsecured." If you can't pay it, your house is not at risk because most states have homestead exemptions that make it impossible for creditors to force the sale of all but the most expensive homes (think mansions). While a home equity loan or a HELOC might be the right choice for you -- knocking double digits off your annual percentage rate of interest -- you must be cautious and fully cognizant of all the risks.
Q: Can I consolidate my debt even if I don't own a home?
A: Yes. Although home equity loans and home equity lines of credit are two of the most popular methods of debt consolidation, they certainly aren't the only options. There are "unsecured" debt consolidation loans available, although they carry with them higher interest rates. And there are other techniques for consolidating one's debts that have nothing to do with borrowing, such as using a credit counselor to establish a debt management plan (DMP).
Q: Does 'debt consolidation' mean taking out a loan?
A: Typically, the term "debt consolidation" is used in conjunction with the word "loan." For example, if you have numerous debts and obligations at a variety of interest rates and maturities, you might take out a debt consolidation loan for the purpose of paying off all of your existing debts, leaving you with only the new loan.
However, this is not always necessarily the case. "Debt consolidation" can also refer to the process credit counselors engage in, in which all of your loans are "consolidated" so that you only have to make one monthly payment. This is the primary feature of a debt management plan (DMP), and only having one check to make out each month can make things a lot easier on debt-ridden consumers.
Q: How much does debt consolidation cost?
A: Debt consolidation can cost a lot, a little, or nothing at all. In fact, an ideal debt consolidation actually saves you money -- that's the whole point!
It really depends on what is meant by "debt consolidation." If you are referring to a debt consolidation loan, then the interest rate should be lower than the composite (average) interest rate you had been paying on your unconsolidated loans. However, even if this is the case, a debt consolidation loan may still be costing you due to a mismatch of maturities. For example, if you had three five-year loans at 18% interest, consolidating them into one ten-year loan at 17% would still cost you more in the long run, even though 17% is less than 18%.
Another type of "debt consolidation" is using a credit counseling company to establish a debt management plan (DMP). In this case, again, the idea is that you should be saving money. Credit counselors should be able to get your creditors to lower your interest rates and forgive old late fees, etc., or why else would you bother? However, there is still a cost, even if you are saving money on a net basis. Credit counselors charge all different types of fees, but a common practice is to charge you one month's worth of debt payments.
Finally, it should also be noted that certain types of debt consolidation can cost you a lot of money. First, we discussed debt consolidation loans, which are presumably "unsecured loans," and then we explored debt management plans, which aren't loans at all. But the third common type of debt consolidation is the secured loan -- most typically, home equity loans. Here, you might be able to really get your interest rates down, but at what cost? If you're unable to make future payments, you've now put your home at risk. With plain-old credit card debt, which is unsecured, your home is never up for grabs since most states have homestead exemptions. Although home equity loans can really help you cut your monthly interest
Q: Once I complete a debt consolidation program, will my credit score improve?
A: Your credit score is a composite of many factors, but generally, paying off a debt consolidation loan will be good for your credit. A history of on-time payments is one of the major factors influencing credit scores, but it cannot be stated with 100% certainty that your credit score will be improved. It is possible you will have taken on other debts, requested more credit, or incurred other credit-related blemishes at the same time you've been working to pay off your debt consolidation loan, all of which could be harmful enough to your credit score to negate the good work you would have done.
Q: When does it make sense to take out a debt consolidation loan?
A: Whenever considering a debt consolidation loan, you have to evaluate the pros and cons and make a rational financial decision.
Typically, you should be looking to pay a lower interest rate on your debt consolidation loan than the composite interest rate of your current outstanding debts. Ideally, you should look for a loan in which the interest rate is lower than any of your current debts.
But you also have to evaluate the costs. If your current debts have different maturities (i.e. one loan that will be paid off in two and a half years, another in three, another in five, and another in seven), then calculating the cost-benefit of a debt consolidation loan becomes trickier. Even with a lower interest rate, a maturity longer than the average maturity of your current loans could result in a higher final payback.
Ultimately, you may decide to pay a higher interest rate if you can stretch your loans out further. If, for example, you had a few three-year and five-year loans at interest rates of 8-15%, you might be willing to pay 16% on one, consolidated ten-year loan. Even though your final payback would be much higher, your monthly payments would be much, much lower, thanks to the longer maturity. Borrowers should be cautious about focusing on the monthly payment instead of the total debt, but in some cases, it is appropriate. You have to educate yourself about all of the pros and cons of a particular loan, and make a rational, informed decision.
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