The Good and Bad of Debt Consolidation

Are credit card interest rates eating you alive? Tired of juggling multiple debt payments each month? Thinking about just rolling everything into a single bill with a mortgage debt consolidation loan?

Tapping your home equity to pay off other debts can simplify your life and save you a lot of money. But it can also lead to big trouble if you’re not careful.

Here’s the upside. Credit card rates are going through the roof right now, while mortgage rates remain unusually low. Credit card companies have been increasing rates and fees in anticipation of new consumer protection rules, with the result that cardholders who may have been paying 5-7 percent interest may now be paying 14-17 percent or even higher.

By contrast, a home equity line of credit can be had for as little as 5-6 percent, with rates somewhat higher for a home equity loan or cash –out refinance of the entire mortgage. And for most borrowers, the interest is tax deductable. So swapping out your high-cost credit card or other debt for low-cost, tax-deductable mortgage debt can be very attractive.

Now for the downside. Credit card debt is unsecured, while mortgage debt is secured by the value of your home. That is, if you don’t pay your credit card bills, there isn’t a lot they can do to you other than trash your credit rating and subject you to endless phone calls. But they can’t come after your property or wages. But if you fail to make your mortgage payments, they can take your home.

So when you convert credit card or other personal debt to mortgage debt, you’re exchanging an unsecured obligation for a secured one. So you might be saving money, but you could also be putting your home at risk – moving that extra debt onto your mortgage could be the difference between staying current and falling into foreclosure if worst comes to worst.

Reduce high-interest debt

A debt consolidation home equity loan or line of credit can make sense if you have substantial other debts where you can significantly reduce your interest costs by refinancing. For example, if you have $20,000 in credit card debt at 14 percent interest, you’d have to pay $310 a month to pay it all off within 10 years. Converting it to mortgage debt at 6 percent interest would let you pay it off in the same length of time for only $220 a month – a monthly savings of $90. So while the savings are significant, it’s not a magic wand to eliminate debt.

You can often structure a home equity loan or cash-out refinance over a longer term than other debts, taking a debt that amortizes over 10 years and stretching it out over 20-30. This will probably reduce your monthly payments even more than just the savings on interest alone will do, but it will increase your costs over the long run, since you’ll you paying interest for a longer period of time.

Don't forget the fees

Home equity debt consolidations have other wrinkles you need to be aware of as well. A refinance or second mortgage/home equity loan will come with fees that you’ll need to pay and take into account when figuring potential savings. And while a home equity loan typically has few or no fees, the interest rates are typically variable, meaning you could end up paying more than you originally expected.

Probably the biggest problem faced by people who take out debt consolidation loans is that they begin to gradually accumulate new debt once they’ve consolidated their old ones. With the credit card balances at zero, they figure they can easily manage a gas or grocery purchase, a few clothes, maybe a couple airline tickets – and before you know it, their secondary debt is out of control again, only now they have a bigger mortgage payment as well.

There’s a general perception right now that it’s almost impossible to obtain a home equity loan these days, for debt consolidation or any other purpose, due to tight credit restrictions. But while it is considerably more difficult than before, banks are still lending to those who retain sufficient equity in their homes and live in areas where housing prices are relatively stable. The important thing is, don’t just focus on the lower interest rate you can get with a debt consolidation – look at the entire financial picture and make sure it makes sense for you.