 What is a Consolidation Loan?
A consolidation loan is any loan you take out to pay off other creditors. To get a consolidation loan you usually need collateral. We will focus on home consolidation loans because most people end up putting their home up as collaterally, but many of the principles discussed in the section apply to other consolidation loan programs as well.
Unlike credit consolidation, the term "consolidation" is accurate when referring to home consolidation loans. That is because you will use the equity in your home to pay off your creditors. Your debts then become "consolidated" into your mortgage loan so you can pay off your debts by simply making your mortgage payments on time.
The most touted benefit of the home consolidation loan is that you can usually count the interest you pay on your home mortgage as a tax deduction. This is true depending on your tax situation, but talk to your tax advisor before you take the banker's word for it.
That said, a home consolidation loan is a quick way to get your hands on a stack of cash if you have equity in your home. That means you can pay your creditors off in full before you accrue any high interest and late fees. Additionally, if you never been late on payments you can pay your debts off before there is anything negative to report to the credit bureaus.
The unfortunate truth about consolidation loans is that they rarely stop the cycle of debt. Let us explain....
Trading equity for debt is never a good idea.
With a consolidation loan you replace home equity with debt. This means you will probably owe more money on your home that it is actually worth. This can become a problem when it is time to sell you home. A common situation is that home values fail to appreciate fast enough to absorb the debt. This has the effect of "trapping" you in your current home because you cannot afford to payoff your mortgage should you sell it.
Turns unsecured debt into secured debt.
With a consolidation loan you are turning unsecured debt into secured debt. Here is why that matters. If you decide to stop paying your credit cards bills your creditors can not lay claim to any of your assets unless they win a judgment against you in a court of law. A mortgage loan is different because it is secured debt. This makes it much easier for the mortgage company to take your home away from you if you stop making your monthly mortgage payment.
Treats the symptom without curing the disease.
Consolidation loans fix the immediate problem without necessarily solving the issue. One of the hidden benefits of a debt settlement and debt consolidation programs is that they teach you the habits of saving and paying your bills on time. Sadly, many people who take out consolidation loans get their hands on a stack of cash only to wind up back in debt.
Home consolidation loans are expensive.
Home consolidation loans are an expensive way to pay off your debts. Yes, current interest rates are extremely low, but consider this example. If you pay 6% interest for 30 years on $20,000 worth of debt your monthly payment will be approximately $120 per month. That sounds low until your remember that you will be paying that amount every month for 30 years. Over 30 years this amounts to $43,167 to pay off $20,000 in debt. Ouch! Worse, unlike a home, your debt will not appreciate.
Home consolidation may not be an option.
Home consolidation loans are out of reach for many people. To get one you need a home, good credit, and extra money to cover the application and closing fees. Without those three things you are not likely to qualify. In summary, the problem with consolidation loans is that you use equity to pay down debt. Be very careful because this could destroy your financial future.
Despite the numerous downsides, consolidation loans may be right for you if you have stable employment, good credit, and some equity in your home. You will need to consider another debt relief option if you don't have these three things.
NOTE: If you have not refinanced your home in several years you should seriously consider doing so. Interest rates are at their all-time low. The savings alone may be enough money to pay down your debts WITHOUT taking any equity out of your home. |
