Debt consolidation describes the process of combining various different loans into one mortgage, usually via home refinancing.
Because a mortgage is a loan secured against property, it normally has the lowest interest rates in terms of consumer loans.
And with the high amount of funds a home owner can obtain due to a considerable home value, it makes financial sense to leverage home equity to pay off all existing debt with much higher interest rates.
Home owners often do this by either taking up a home equity loan either through a second mortgage or cash out, home equity line of credit, or even package it into a first mortgage before buying a house
Once the facility is approved and disbursed by the lender, the borrower will use the funds to pay off all existing debt obligations.
When the facility is a term loan, it is repaid with monthly installments similar to a typical mortgage.
For example, a homeowner might have credit card bill totaling $5,000 at 20% and a 7% auto loan with a balance of $10,000 paid with a monthly installment of $500.
Should the borrower have a house worth $100,000 with $40,000 at 6% balance outstanding, he can refinance the loan at 5% with cash out totaling $70,000 (assuming a 70% LTV) and pay off the remaining home loan, credit cards, and auto loan altogether.
The balance of $15,000 can be used for personal expenses or however he like.
In effect, the borrower saves 15% by clearing the credit cards, 2% by redeeming the auto financing, and 1% from refinancing the previous mortgage.
In addition to that, he has generated $15,000 additional funds to repay any other debt that has been a source of stress.
Not too shabby.
If the borrower is financially in the pink of health, shortening the tenure of the new loan will not only mean he incurs even lesser cumulative interest, but also pay off the whole debt at faster rate. Albeit with a higher monthly repayment amount.
When we take into account the tax deductible nature of mortgage interest, it does make a strong enough case for debt consolidation.
Plus, instead of having to keep track of so many debt commitments, the borrower will now only have 1 monthly debt repayment to remember.
Disadvantages of consolidating loans
The main problem that causes home owners to stay away from such financial re-structuring is that they are effectively putting their homes on the line.
Should they default they run the risk of losing their homes to foreclosure.
If they already have a history of having problems with repaying debts, this time it’s not only their personal credit that could suffer.
This time, it’s not just the house, but also the family at stake.
Because of how easy some homeowners might realize generating cash from home equity is, they might also cash out again and again to solve cash flow problems.
This behavior can lead to a downward spiral of increasing debt if not left in check.
When the loan amount gets close to or exceeds the property value, it might be difficult for the homeowner to refinance the house in future… because it would be crazy for a lender to finance a house worth $100,000 for $110,000.
It just don’t make sense.
Debt consolidation with unsecured loans
In practice, it makes the most sense to consolidate debt with secured loans against assets as collateral. This is because the interest rates on secured debt is lower.
However, a lot of people and entities are consolidating debts for the purpose of consolidation without wanting to put their homes at risk.
When interest rates are high or comparable to existing debt, there are no real interest costs savings. But borrowers will now only have a single loan to look after rather than 5.
The problem with unsecured debt consolidation loans is that they don’t really serve the market that really needs it.
This is because lenders would only lend to those with good credit and charges a high interest rate.
The average individual who is looking into consolidation is very likely having cash problems with a high probability of having undesirable records on the credit report.
Whatever the reasons for signing up for these loans, just be careful not to fall into the jaws of predatory lenders.