Thinking about a debt consolidation loan? For someone with a lot of credit card debt and other obligation, rolling all those bills into one monthly payment can seem like an attractive option, particularly when you can get a lower interest rate in the bargain. But there are downsides.
Debt consolidation loans can take a variety of forms. If you have equity in your home, you can refinance your mortgage to take cash out to cover other debts, or simply take out a home equity loan or line of credit. You can also take out an unsecured personal loan, although that has become increasingly difficult and expensive in the current credit markets.
With the wide gulf right now between mortgage interest rates and credit card rates, consolidating debts through refinancing your mortgage can make a lot of sense. If you've got $10,000 in credit card debt on which you're paying 20 percent or more, but can roll that debt into your mortgage while refinancing at 5.5 percent, that's a pretty compelling case for a debt consolidation.
Problems with consolidating debt through your mortgage
However, many experts would advise against using a mortgage refinance to consolidate credit card and other debt. Although you can simplify your finances and save money through a mortgage refinance or home equity loan, such an arrangement can actually lead to more serious trouble if you don't keep a close handle on your finances going forward.
Here's how it works. Say you owe $150,000 on your mortgage, but your house is worth $300,000, even after the recent decline in housing prices. You're presently paying 6.5 percent on your mortgage and owe $10,000 on various credit cards at rates ranging from 13 to 21 percent. You refinance your mortgage to a balance of $164,000 at 5.5 percent interest, taking $10,000 out to pay off the credit cards.
Now you still owe that same $10,000, but you're paying it off at only 5.5 percent instead of 13 to 21 percent annually. That interest is also now tax-deductable because it's on a mortgage, and you're also paying a lower rate on the original $150,000 balance. What's not to like?
Well, for starters, look at that extra $4,000 you took out of the loan - you refinanced to $164,000, remember? That $4,000 is an approximation of the closing fees you'll need to pay for taking out a new mortgage, same as you did when you first bought the home. Those fees effectively reduce any savings you realize from rolling your credit card debt into the mortgage and reducing your interest rate overall. You have to account for it when figuring how much you might save by consolidating your debts and refinancing.
Unsecured vs. secured debt
But the main reason experts advise against tapping your mortgage to pay off credit card debt is that you're exchanging unsecured debt for secured debt. Credit card debt is unsecured - if you don't pay it off, there's really not much the lender can do to you aside from dropping your credit rating and harassing you for payment. A mortgage is a secured loan, however - secured by the property you've mortgaged. If you fail to make those payments, you could lose your home.
In addition, many borrowers continue bad credit habits after getting a debt consolidation loan. Once they've paid off their credit cards and rolled everything into one tidy monthly payment, they feel like they're starting out with a clean sheet, so to speak. There's often a temptation to start making small purchases again, which before they know it, start piling up and eventually they're looking at a large credit card debt once again, only now it's on top of their debt consolidation loan as well.
Home equity loan, HELOC also are options
There are other ways to obtain a debt consolidation loan besides refinancing a mortgage. A home equity loan or line of credit (HELOC) is another way to tap your home equity, although the rates are typically higher than a mortgage refinance and these come with various fees as well. You can also try to obtain an unsecured personal loan, although that's increasingly hard to do in the current credit market and you may end up paying a high interest rate.
The main thing is, if you do take out a debt consolidation loan to deal with credit card and other debts, you need to be disciplined in how you handle your finances going forward. Otherwise, you may find yourself falling right back into the same debt trap all over again.