To consolidate debt or not to consolidate debt used to be a foregone conclusion. When housing prices were rising and home equity was plentiful, debt consolidation via a home equity loan was a no-brainer. Today's plummeting market, however, has changed the playing field.

Debt consolidation used to be the mantra of people with heavy consumer debt. With budgets squeezed tight from excessive spending, consumers used a variety of debt consolidation methods to lower their monthly payments.

On paper, the idea of increasing your cash flow every month seemed like a great idea. Indeed, it spurred millions to use their home equity to erase high interest credit card debt. Problems in subprime lending, and a poor housing market, however, have caused people to rethink the old ideas behind debt consolidation.

Home equity loan not always the answer

Using home equity for consolidation has significant advantages. If you take out a second mortgage-either an adjustable-rate home equity line of credit (HELOC) or a fixed-rate home equity loan-you'll generally have a loan at a very low interest rate. Furthermore, the interest you pay will be tax-deductible, as the loan uses your home as collateral. (Interest payments on a first mortgage are tax-deductible, too.) However, using mortgages for debt consolidation can be tricky. Just ask the millions of people in foreclosure.

The problem with using debt consolidation is twofold. First, your home is at risk. If you can't make your mortgage payments, you could lose your property to the lender. Second, you need to be particularly careful about the type of mortgage loan you use for debt consolidation. Many of the problems with the subprime lending crisis can be attributed to the fact that people used adjustable-rate mortgages. When these loans adjusted upwards from their low introductory rates, shrinking home values prevented homeowners from re-qualifying for a new mortgage loan. Use caution, and select a debt consolidation mortgage that makes sense.

Other methods of debt consolidation

If a home equity loan isn't the answer, what other choices do you have? Surprisingly enough, credit cards may be a good choice for consolidating debt. If you can find a credit card with an interest rate lower than the rate on your current cards, you'll instantly save money on interest charges. Unfortunately, while credit cards often offer a low introductory rate for balance transfers, these rates tend to increase after a six- or nine-month period.

Non-secured debt consolidation loans are another alternative, although some carry high interest rates. They may beat the rates on certain credit cards, but you should approach this type of loan with caution.

The best choice for debt consolidation is to pay off your debts in a regular, disciplined manner. More importantly, resist the temptation to max out your plastic once they're clear. Recovering from heavy debt is extremely difficult, and it's a painful process that you don't want to experience twice.

Published on January 7, 2009