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Consolidation Loan, Part 1
For many people a consolidation loan is the first strategy they seek when trying to get out of debt.
Debt consolidation loans can be very attractive, since they typically offer lower monthly payments. In addition, most people find that making one monthly payment can give them a better sense of where their money is going, and how much they have left to pay off.
There are a number of ways to consolidate bills. Some methods, such as switching to cheaper credit cards, are easy. Other options are more complicated and require tough trade-offs. For example, if you’re a homeowner, should a homeowner take a home equity loan to pay off credit card debts? How about borrowing against your retirement plan at work? Or should you tap the cash value of an insurance policy?
Before you rush out to obtain a debt consolidation loan or a home equity loan to lower your monthly payments, ask yourself three basic questions:
1. Is getting out of debt the real reason I want a consolidation loan? If you want to lower your monthly payments only to put more cash in your pocket, and you are unwilling to make any changes in your spending habits, you probably are not a good candidate for another loan.
2. If I obtain a new loan, am I willing to stop buying on credit? Again, the goal of a consolidation loan should be to help you reduce your overall debt level. If you are going to use another loan as a cash “windfall” to begin charging new purchases, forget it.
3. Will the new loan reduce my overall debt load? Make sure you carefully consider the cost of a consolidation loan. If the interest rate on the new loan is equal to or higher than the average rate on your current loans, if there are expensive fees or closing costs attached to the loan, or if the monthly payments on the new loan are so low that they stretch the length of your debt by several years, look elsewhere for help.
If you still think you are a good candidate for a consolidation loan, here are some options for you to consider:
Use Plastic
Switching from a high-rate credit card to a low-rate card can easily save the average person at least $100 or more a year in interest, and even more over the life of the loan. If you haven’t already tried to negotiate a lower rate on your credit cards or consolidated your debt onto lower-rate cards, what are you waiting for?
Once you have consolidated to a few cards and carry a reasonable amount of credit card debt, you are likely to be approved for the loans you need.
Personal Loans
Most banks offer unsecured lines of credit of several thousand dollars. Interest rates on these loans tend to be slightly lower than average credit card rates, but higher than lower-rate credit cards. If you are interested in a personal loan, check with your own bank first, since some offer better terms and easier approval criteria for their regular customers. Just like with credit cards, bankers are unlikely to extend you a consolidation loan if they think you have too much credit already. People with lots of debt, or even lots of available credit, may be considered poor credit risks, since they could turn around and charge their cards up to their limits tomorrow.
Home Equity Loans
There are two main ways to tap into your home’s equity: through a second mortgage or a home equity line of credit. Both of those loans are types of home equity loans. A second mortgage is a loan for a fixed amount. As with other installment loans, you are given the entire amount of the loan at once, and pay it back in regular monthly payments. With a home equity line of credit (HELOC), you are approved for a loan of a certain amount, and then can borrow up to your “credit limit.” You can think of an HELOC as something like a credit card, since you are free to borrow as needed and your payments will be based on the amount you have actually borrowed.
Because home equity loans offer valuable tax advantages, they can be an attractive device for consolidating your debts. In most cases, you can deduct home equity loan interest on loans up to the value of your home (but not on any portion of a loan that exceeds your home’s value). This only applies if you itemize on your taxes, however.
Here’s an example of how a home equity loan can help. Suppose you are paying off a credit card debt of $5,000 at 19.8 percent interest. Your first year’s interest would be $847—and none of that interest expense would be tax deductible. However, using the proceeds of a home equity loan to pay off this debt would offer you two advantages: 1. You could probably get the home equity loan at a much lower interest rate (I’ll use an example of 10 percent), and 2. The interest you pay would very likely be tax deductible. In the first year, tax deductions on a $5,000, five-year loan at 10 percent interest would amount to a savings of $129.69 while the reduced interest rate would save you $384.61.
Most lenders offer home equity loans equal to anywhere from 50 to 80 percent of a home’s value, minus the first mortgage. Suppose, for instance, your house is now worth $125,000, and you still owe $45,000 on your first mortgage. You would usually be eligible for a home equity loan of between $17,500 and $55,000.
Some subprime lenders offer loans totaling 100 percent to 125 percent of the value of your home. These can be particularly dangerous if you need to sell your home or if home values stagnate. Being “upside down” and owing more than your home is worth puts you in a very tenuous financial position should anything go wrong.
Before you put your home on the line, ask these questions:
1. What is the loan’s interest rate?
Home equity loans are often available at interest rates below other consumer loans. This makes them a good source for refinancing expensive, nondeductible consumer loans. Most home equity lines of credit carry variable interest rates, which means the interest rate will change as rates in the economy change. Higher interest rates mean higher payments, so it is very important to take into account whether you will be able to afford your payments when interest rates go up.
Some loans feature “interest only” payments. Attractive because the payments are so low, these loans can be very dangerous, since you are not paying down the principal balance of the loan. Interest-only home equity loans are best used to tide you over in tough economic times when those low payments are the only way to keep you out of a serious financial crisis or bankruptcy.
Watch out, too, for ”teaser rates”—interest rates that are offered for an introductory period only. These are commonly used to lure consumers into the bank for a hard sell on a loan that can end up costing a lot more than advertised. Shop for interest rates by comparing the APR (Annual Percentage Rate).
2. What are the fees?
Fees and closing costs on home equity loans can range from nothing to thousands of dollars. Closing costs may include an appraisal fee, a recording fee, title insurance, and a title search. Be sure to ask for a full disclosure of all fees before you sign on the dotted line.
A “loan origination fee” may be charged up front. This fee is often one “point”—and a “point” is 1 percent of the loan amount. If, for example, your lender charges one point as a loan origination fee, and you are taking out a home equity loan of $10,000, you will pay $100 for this fee. This fee usually covers the cost of preparing loan documents, packaging the loan, and other loan processing services.
3. Is the interest tax deductible?
Generally, you can deduct the interest on home equity loans to a maximum of$100,000.
Suppose the current market value of your home is $200,000. Your outstanding mortgage is $120,000. The lender approves a home equity loan of $40,000 (80 percent of the home’s value, minus the first mortgage). The difference between the market value of your home and the current mortgage ($200,000 minus $120,000) is $80,000. You could deduct interest on a home equity loan of up to $80,000 of home equity debt and still deduct the interest. Therefore, the interest on your $40,000 loan in most cases would be completely deductible.
If you are using your home equity loan to pay for educational or medical expenses, interest payments may be fully tax deductible regardless of the amount. Since the tax laws are constantly changing, be sure to check with your tax advisor before applying for a home equity loan to make sure you are aware of all the rules regarding deductibility.
If you take out a home equity loan to pay off your credit cards, be very careful. If you don’t change your spending habits, you’re likely to treat the home equity loan as extra income, and run up new balances on your credit cards. For that reason, you should cut up, close out, and send back your credit cards. You may even want to limit yourself to a travel and entertainment card like American Express, which you must pay in full each month. Do not take out a home equity loan that offers access by credit card. That’s only asking for trouble!
A home equity loan may or may not appear on your credit report, depending on whether the lender chooses to report it. (If you don’t pay on time, of course, the delinquency will likely be reported to at least one of the major credit bureaus.) If your home equity loan does appear on your credit record, beware: A large available line of credit, even if you don’t tap all of it, may make other lenders shy away from granting you additional credit. That means your applications for other credit could be turned down simply because you have a huge line of credit available.