Evaluating Debt Consolidation

If you are like most Americans, your mail box is filled with offers for credit cards, mortgage refinancing and home equity loans. Many of those offers stress the benefits of moving existing balances to the new lender. While that may sound appealing, especially if the new loan offers an attractive initial interest rate, it is important to consider all the factors associated with debt consolidation.

Debt Consolidation is Debt Management, Not Debt Elimination
Moving all your outstanding loan balances to one lender will not reduce the amount you owe. You must ultimately pay off the loan and pay interest until the loan is repaid. Your goal should be using debt wisely. Here are some reasons to consider debt consolidation:

  • Lower rates - Different types of loans have different rates. Credit card debt usually carries higher rates than loans that are secured by an asset such as a home or car.
  • Lower payments - You payment is determined by the amount you are borrowing, the rate being charged and the length of time over which you are paying off the loan.
  • Tax benefits - The interest you pay on a home mortgage or home equity loan may be tax deductible while interest on credit card debt and most personal loans is not. Consult your tax advisor for more details.
  • Peace of mind - Dealing with one lender, making fewer monthly payments and having a plan for paying off your total debt can reduce your financial anxiety.
  • Improve credit record - Having fewer debts and making timely payments can make it easier (and potentially cheaper) to secure loans in the future.

The starting point is to determine what you have borrowed and the interest you are currently paying. Here is a worksheet that can help.

Existing debt information
Lender Amount borrowed Interest rate
Credit card 1 $ %
Credit card 2 $ %
Credit card 3 $ %
Credit card 4 $ %
Store card 1 $ %
Store card 2 $ %
Store card 3 $ %
Auto loan 1 $ %
Auto loan 2 $ %
Home mortgage $ %
Home equity loan $ %
Other real estate loan $ %
Other loan 1 $ %
Other loan 2 $ %
Other loan 3 $ %
Summary
Description Amount of borrowing Average interest rate Monthly interest
Credit cards
Store cards
Auto Loans
Real estate
Other
Total
Interest is compounded monthly. This calculator is to be used for estimation purposes only. The financial institution is not responsible for its accuracy and the results are not guaranteed.

Next steps

  • Examine the types of debt you have and the rates you are paying.
  • Are these the types of debt you want? - There may be less expensive alternatives within the category such as replacing your credit card with one that offers lower rate. You may also wish to consider converting one type of debt into a different type that offers lower rates, such as using a lower interest rate home equity loan to pay off other more expensive types.
  • If you decide to replace debt with debt secured by real estate (mortgage or home equity loan), consider the alternatives and remember the risks. You will be pledging your home as collateral.

Investigate the Attractions of Home Equity Loans

Convenience - It easy to apply and the approval processes can be fast. The process is often simpler than if you were applying for a new mortgage. Once you are approved, the commitment acts like a line of credit. You do not have to borrow it all at once.
Interest rates - The interest rates charged on home equity loans are usually greater than those on first mortgages but less than those on credit cards. Often, you are only required to pay the monthly interest with the principal to be paid later.

Tax benefits - For many individuals that itemize their tax deductions, the interest paid on home equity loans can help save some income taxes. There are some limits on this type of interest deduction so consult with your tax advisor for more details.
Flexible uses - Even though you are borrowing against your house, there is no requirement that the money be used on your house. A home equity loan can be the source of funds for paying off credit card balances, college tuition or even to buy a car.

Home Equity Loan Payment Comparison Calculator
Debt you are considering replacing with a home equity loan $ Interest rate on that debt %
Home equity loan interest rate % Marginal income tax bracket
Monthly interest on existing debt balances
Monthly interest by replacing existing balances with home equity loan
Monthly savings
Potential tax savings by deducting home equity loan interest (Consult your tax advisor for details.)
Interest is compounded monthly. This calculator is to be used for estimation purposes only. The financial institution is not responsible for its accuracy and the results are not guaranteed.


Summary

You owe it to yourself to determine if consolidating your debts into one loan makes sense. You may be able to reduce your interest rate and if you use a home equity loan, you may be able to save some taxes. However, just like with any financial transaction, you must consider all the factors and risks.

 

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