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 If you're thinking about debt consolidation, then you're probably trying to figure out if your best option is a debt consolidation mortgage or a consolidation loan. For those of you trying to decide which option is the best way to go, here are some of the more important things that you should consider.
Debt Consolidation Loans
With the rapid rise of credit card debt, there has been a growing demand in debt consolidation loans. Admittedly, there are many ways to tackle this problem including some very practical options such as budgeting. But for argument's sake, let's say you've got your mind made up that you need a debt consolidation loan.
If you step back and think about the concept, you might have outstanding bills with a couple of creditors - your electric company, and perhaps credit cards of various types. Each company is sending you nasty threats via their collection agencies and you're having trouble juggling all these balls at one time. This is what is makes consolidation loans so appealing. They put everything in one place - But at what cost?
Consolidation Loan Costs
Well, if you're the lending someone money then you've got a business to protect. You're potentially dealing with someone that is having trouble making ends meet and you want assurances that you're going to collect your monthly payments on the loan.
So effectively the lender says to the client or customer - "I'll assume all the risk of non-payment, but just to make sure you pay me back, I need some collateral and your home would suite me fine." In fact, it is the use of a home as collateral that makes debt consolidation loans look very much look like a refinancing mortgage or a home equity loan.
Consolidating Debt via Home Equity Loans
Many lenders will allow you to borrow money if you've got enough equity in your home. Equity is simply calculated by taking the current market value of your home and subtracting any mortgages or other loans you've already got using the home as collateral.
Home Equity Example
So if you home is worth $300,000 and you've got $70,000 left on the original $100,000 mortgage, then you've got $300,000 - $70,000 or $230,000 of equity in your home.
Most home equity lenders will allow you to borrow up to 80% of the equity you have in the home. So continuing with our example, you could borrow up to $240,000 x 80% or $192,000.
With the rapid rise of real estate in some part of the country, most individuals could take out a home equity loan to pay off their credit card debt, but there are some pros and cons to this approach.
Pros of Home Equity Loans
The nice thing about a home equity loan is that the payback terms on the loan are usually in the 5 to 20 year range - nearly as long as a typical mortgage. This means you can take $30,000 in credit card debt and pay it off over the next 20 years. This new loan can lower your monthly payments to a more manageable number. Another nice feature of a home equity loan is that you don't have to pay closing costs as you would with a mortgage.
Income Taxes and Home Equity Loans
Generally, homeowners can borrow up to $100,000 and still deduct the interest when they file their federal income tax returns. There are some other restrictions, especially with 125% loans (home equity loans for 125% of the equity in the home). It's always a good idea to check with a tax accountant to see how the tax law applies to your situation.
Cons of Home Equity Loans
The real problem with using home equity loans to consolidate debt stems from the cause of the problem in the first place. Let's say it took you five years of "overspending" on your credit cards to finally realize that you need help managing your monthly payments. But the nice thing is that your home has gone up in value over that same time. So why not just take the equity out of the home and put it to good use?
The problem is that your home might be worth more, but when you take out a loan you've got to pay the money back. If you start up the same pattern of overspending, then you will soon end up in the same situation again. A home equity loan treats the symptom, but it is up to you to stop overspending.
Cash Out Mortgages
The second option you have is really closer to the concept of a true debt consolidation mortgage. A cash-out mortgage is simply refinancing your home with a primary mortgage that is large enough to provide you with money you can use for other purposes such as paying off outstanding debt.
Cash Out Mortgage Example
For example, let's say you've got a home worth $300,000 with $80,000 left on the original $100,000 mortgage. With a cash-out mortgage, you might decide to refinance your home with a new mortgage of $110,000. You can use $80,000 of the new mortgage to pay off the old mortgage. You would then have $110,000 - $80,000 or $30,000 to pay off credit card or other debt.
Pros of Cash Out Mortgages
With the larger size of a cash-out mortgage you will usually find a lower interest rate compared to other loans. There is also a better chance that the interest on the mortgage payment will be fully tax deductible. Finally, with the longer payment terms on first mortgages, you are effectively spreading your debt consolidation loan over a longer period of time and lowering your monthly payments.
Cons of Cash Out Mortgages
A cash-out mortgage will require that you go through a home closing again, which is a big disadvantage. This means you will have to pay all of the closing costs and fees typically associated with a new mortgage. You should also pay attention to the interest rate or APR on any new mortgage. If your existing mortgage has a lower interest rate than the cash-out mortgage, then you might be better off funding your incremental debt with a home equity loan.
And although it sounds nice to be able to lower your monthly payments via a debt consolidation mortgage, keep in mind that you might be paying off that new television over for the next 30 years - so take good care it.
Online Mortgage Calculators
At last count we had over a dozen online mortgage calculators that you can use as often as you'd like. We've also got a complete line of personal loan calculators too. These tools can help you compare mortgages, figure out what it takes to pay off a mortgage or even evaluate the refinancing options you've got. So take a little time and run through a couple of scenarios. You might be surprised at how much, or how little, a debt consolidation mortgage will cost you.
About the Author - Debt Consolidation Mortgage
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