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Does Debt Consolidation Make Sense?

Reviewed Jun 21, 2013

Summary

Debt repayment plans only work in the long run if they change your behavior. Be careful to keep your spending in check, especially if you still have credit cards available.

Can new debt really solve your debt problem? If you’re strapped for cash and maxed out on credit cards, the idea of rolling over all those bills into a fresh, low-interest loan can look mighty tempting. And plenty of lenders and mortgage brokers seem more than willing to help you borrow your way out of trouble.

Their typical offer is this: You can get rid of high interest rates, cut your payments and buy time by consolidating your high-interest debt in a lower-interest loan, with the equity in your home as collateral.

Other services advertised under the “debt consolidation” label are actually debt repayment plans, in which an agent works out easier terms with your creditors allowing you to pay down the debts in a program of monthly payments.

Either of these strategies might work, say debt management experts, but only if you have the discipline to cut back on spending and start saving.

Your success depends a lot on how your trouble started in the first place. John Waskin, head of the non-profit American Credit Counselors Corp. in Huntersville, N.C., says borrowing on the equity in your home to pay down debts can make sense for someone who has managed money well but is suddenly hit with a big, unforeseen expense, like medical bills from a serious illness in the family. “It’s not that you’re a disorganized person,” Waskin says, “It’s just that life threw you a curve.”

Even then, he points out, you have to be careful to keep your spending in check, especially if you still have the credit cards available. “We’re the only business that doesn’t want repeat customers,” he says. And one thing he doesn’t want to see is a client coming back a year after debt counseling with two big problems this time—a home loan to pay off and a lot of new credit-card debt.

Your home at stake

Debby Vinyard, a financial planner in Marion, Ill., has a similar warning. She says borrowing against home equity to pay off credit cards can indeed lower your monthly payments, as advertised, but you’re asking for trouble if you don’t have a plan to retire your debt. The problem with these loans, Vinyard says, is the borrowers’ “tendency to spend up to the higher debt level until payments are just as high as before.”

Home equity debt also carries a risk that unsecured debt, such as credit cards, does not: You could lose your house if you don’t make the payments. With unsecured debt (not backed by any collateral), it’s far more difficult for lenders to get their money back if you default; that risk is the reason for the much higher interest rates.

With those cautions in mind, the math of debt consolidation loans can be appealing. For instance, if you have $30,000 in credit-card debt with an interest rate of 14 percent, you typically would have a minimum payment of $900 a month (or 3 percent of the principal). If you pay that amount faithfully and don’t borrow another cent, it would take you about 22 years to pay off the debt.

Rolling this debt over into a home equity loan at 8 percent with a term of 10 years would cut the monthly payments to just over $360. The loan would take slightly longer to pay off, but the interest can be tax-deductible if you itemize deductions and your loan qualifies under IRS rules (see “Resources” below). You might also be able to do a “cash out” refinance by increasing the principal of your existing mortgage. For those with good credit, rates on refinanced mortgages have dipped to historic lows in recent years—such as below 5 percent for 30-year fixed loans.

As Vinyard and others note, though, home equity credit isn’t a free lunch. Not only is your home at stake, but the balance due on the loan is lopped off the value of your home if you sell it. Vinyard says home-equity borrowing isn’t a good idea if you move (and sell homes) frequently, especially if you’ve borrowed so much that you may owe more on a home than a buyer is willing to pay for it.

Also, the best rates are only available to borrowers with excellent credit scores. These are people who have no trouble handling their debts and who don’t need to tap home equity to pay off credit cards. You also need to have plenty of equity in your home. The real estate slump that started in 2007 left millions of homeowners either “under water”—owing more on the home than it is worth—or with too little equity to refinance their existing mortgage at its current principal. And rules on home lending have been toughened, so that a loan you might have qualified for a decade ago is now out of your reach. Even if a loan is available, the interest rates based on their credit score may be so high that it would make more sense to pay down the credit cards through a repayment plan.  

Debt repayment plans

As for the latter alternative, the risks are different but still significant. In signing up with an organization  that promises to work out a payoff plan and lower your monthly payments, you need to watch out for unscrupulous firms that make a profit by taking your money upfront. Waskin says you should seek out non-profit credit counseling agencies that don’t charge fees as a condition of helping you (a true non-profit relies strictly on donations). And debt repayment plans only work in the long run if they change your behavior. The only solution that lasts is to learn how to spend less than you earn, and to make saving a lifelong habit.

Resources

Federal Trade Commission
http://www.consumer.ftc.gov/topics/dealing-debt
To see if your home equity debt would be tax-deductible, review IRS Publication 936. In the Table of Contents at http://www.irs.gov/publications/p936/ix01.html, go to the links at “Equity Debt.”

For some more tips (and cautions) on debt refinancing, see the Federal Reserve Board's “What you should know about home equity lines of credit” at http://files.consumerfinance.gov/f/201204_CFPB_HELOC-brochure.pdf

To find credit counselors in your area who can help with debt repayment, a good place to start is with the National Foundation for Credit Counseling (http://www.nfcc.org, or call 1-800-388-2227).

By Tom Gray
Source: John Waskin, executive director, American Credit Counselors Corp.; Debby Vinyard, CFP, Vinyard & Associates Financial Planning; Federal Trade Commission; Federal Reserve Board; Consumer Bankers Association.

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