What you should know before trying to consolidate debt
You’re worried that your debt is too high, and you’ve decided to do something about it. That’s good. Debt consolidation may save you both time and money. Your next move depends on your own personal financial situation.
Define your goal: lower payments, or faster payoff.
The idea behind debt consolidation is a simple one: combine several higher-interest debts into a single, lower-interest debt. This can benefit you in two different ways. First, with a lower interest rate, you may be able to lower your monthly interest payments so you have more of your hard-earned cash available for other important needs. Alternatively, a lower interest rate could allow you to apply the interest savings to the principal of the loan — and pay the debt off faster.
Explore all the options.
Here are the three most common ways to consolidate debt:
- Take advantage of low credit card balance transfer rates. For example, why pay 24 percent on three separate credit cards when you could pay 15 percent interest on one card? Note: credit card issuers typically charge a balance transfer fee. This is typically around 3 to 5 percent of the balance you transfer.
- If you have available equity in your home, a home equity loan or home equity line of credit often carries a lower interest rate — plus the interest you pay is usually tax deductible (consult your tax advisor regarding interest deductibility). You should note that the monthly payment you will have to make on your home equity loan or home equity line of credit is in addition to your current monthly mortgage payment.
- Apply for an unsecured line of credit (ULOC). A ULOC is similar to a credit card because the bank allows you to access an unsecured line of credit with an agreement from you that it will be paid back on time and with interest. However, you will not receive an actual card. Instead, the bank will provide you with checks to use to access funds from the line of credit.
Secured and unsecured: advantages and disadvantages.
Before you proceed with consolidating your debt, you should understand the difference between a secured loan and an unsecured loan.
- Secured loan — When you take out a secured loan, you agree to put up something of value, such as your home or your car, as collateral for the loan. That means if you don’t pay back the loan, your creditors can take possession of your home or car. Advantage: Because a secured loan involves less risk for the lender, it usually features a lower interest rate. Disadvantage: You could lose your collateral.
- Unsecured loan — An unsecured loan or line of credit doesn’t require any collateral. It’s based entirely on your good credit history. Most credit cards fall into this category, as does an unsecured line of credit (ULOC), which is often referred to as a personal loan. Advantage: You don’t have to put your property at risk. Disadvantage: Unless your credit score is excellent, your interest rate will likely be higher.
Think carefully before you decide to move ahead.
As you investigate your options, look at the final numbers. Is your new loan going to cost you more in the long run? Before you make a decision, ask yourself a few questions:
- Is the rate you will be charged on a new loan or balance transfer offer likely to change over time? If so, will you end up paying more than you are now?
- Some interest rates, known as "variable" rates, can change with the rise or fall of an index, such as the Prime Rate. You can find out the current Prime Rate by visiting www.wsjprimerate.us, or by calling your credit card company.
- Some interest rates may have a built-in expiration date - often 6 months - after which the rate can rise significantly. This is commonly known as an introductory or promotional rate.
- How long is the term of the loan? Will you incur any additional fees, charges, or penalties if you pay your current balances off early (early-payment penalties) or if you miss a payment?
- Are you certain the payments for your new debt consolidation loan will fit within your budget?
Depending on the answers to these questions, you may want to keep your existing loans, even if the payments are higher. Remember that, in some cases, you may actually pay more in interest over time with your new debt consolidation loan.
Determining the merits of various loan programs can require some complicated number crunching. If this is not your strength, enlist the help of a skilled financial advisor.
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