You’re tired of paying high interest rates on credit cards.
You wish it were simpler to handle payments and stay up-to-date on the monthly bills.
If you believe the hype, those two characteristics make you a great candidate for a debt-consolidation loan.
It’s a message you can scarcely avoid these days on television or radio. The pitch is enticing: Get out of debt, enjoy your money more and live a simpler life with fewer bills.
But debt-consolidation loans aren’t always as good as they sound. Moreover, there are many ways to achieve the same goal, namely reduced interest paid on steadily declining debt.
For starters, look at your debt situation realistically. The very convenience and savings offered by a debt-consolidation loan makes it dangerous; if you spend your savings, rather than applying it to the debt, you stand a good chance of someday landing even deeper in the hole.
To consolidate your loans, you have a variety of options, including personal loans, home-equity loans, margin loans on investments, loans against insurance policies or retirement savings, second mortgages or even credit cards.
The first thing to consider, before taking any of those steps, is whether the move will get you out of debt in a reasonable amount of time, say three to five years (assuming a debt currently somewhere between $7,500 and the insurmountable declare-bankruptcy level).
In other words, you start by creating a repayment plan, and then look to see how you can consolidate some or all of your debts to either a) shorten the repayment period or b) lower the interest rate.
“Many people are simply looking for a lower monthly payment, which is a bad idea,” says Gerri Detweiler, author of the Ultimate Credit Handbook. “If all you focus on is the amount of the payment, you could wind up with a high-cost, long-term loan that will cost you a fortune and take forever to pay off.”
As you evaluate any type of loan, look at its total cost in dollars, the amount you will pay to get the debt to zero in its consolidated form.
Here are the types of loans you might consider:
– Personal loans. Banks, credit unions and finance companies generally make personal loans at reasonable rates for a set period of years.
Alas, these loans can be hard to get, as they are considered unsecured debts and you already have some big debts to pay (or you wouldn’t need this loan).
The more shaky you are as a credit risk, the less attractive interest rate you can expect to get.
– Home-equity loans and second mortgages. The idea here is to use your house as security on a loan. The typical home-equity loan or line-of-credit depends on the current value of your home minus your mortgage.
The typical second mortgage, or home-equity loan, lets you borrow a fixed amount over a specified number of years. You may even be able to borrow more than your house is worth.
The advantage is that the interest on the loan is tax deductible (but only on the portion of the mortgage equal to the value of your home; if the loan amount exceeds the home’s value, interest paid on the extra money is taxable).
The bad news is that you are signing up for a long repayment period. The total cost of borrowing this money–especially if you don’t pay it off early–can be astronomical.
You also are literally betting the ranch that you won’t fail to make payments. If your debt problems worsen, you could lose the house. And if you borrow more than the house is worth and then decide to sell or move, you could face an unpleasant surprise if the sale price on the home doesn’t equal the value of the loan. You’ll be expected to make up the shortfall in one lump sum.
Home equity lines of credit–a pre-approved lending limit that can be tapped as needed–may be a better alternative. Here, however, repayment periods can get even longer, stretching out 20 or 30 years; if you aren’t careful, you could be getting out of your current debts while guaranteeing a lifetime of debt.
– Margin loans. Some people wipe out their savings to eliminate debts. Not only does this leave them vulnerable for the future, when they may need those investments, it also creates a tax bill, since Uncle Sam wants his share of the gains on anything sold.
A better alternative may be to borrow against investments. Typically, these so-called “margin loans” can be made for up to 50 percent of the value of the securities, and at attractive interest rates. You may not even have to make payments, instead covering the debt plus interest when you sell the investments.
But remember that a nosedive in the stock market could force a margin call, where you need to replenish your account with more money or need to pay off the loan.
– Loans against insurance policies or retirement savings. If you have a whole, variable or universal life policy, you may be able to borrow against its cash value. You almost certainly qualify, but the rules are tricky; learn how the loan affects premium payments, cash value and death benefits.
On your retirement monies, excepting individual retirement accounts, you typically can borrow at a reasonable rate of interest. Best of all, that interest gets credited back to your account, so it’s like paying interest to yourself.
But if you leave your job, you could have to pay the entire loan immediately. And if you ever miss a payment (by as little as one day), the Internal Revenue Service could treat your loan like a withdrawal, in which case you owe taxes and penalties on the borrowed money.
– Credit cards. The credit card game is increasingly hard to play, because lenders are tightening up. But if you have access to low-rate introductory credit card offers and have the ability to repay the debt quickly, a credit card may be the answer.
Accept a teaser rate (a low rate for the first six months to a year after opening the account) and use cash advances to pay off the debt. Be careful about carrying this debt too long, however, as rates tend to skyrocket when the honeymoon period ends. While you may be able to roll the debt to another credit card, don’t count on it.
To look for good credit card rates, check out www.cardtrak.com or www.bankrate.com (a site that includes rates on all types of loans).
“It comes down to options and choices,” says Detweiler. “Look at everything that is available to you, choose the option that gives you the best chance of getting out of debt. And if you . . . can’t see yourself paying everything off in a few years, a debt consolidation loan won’t save you. In that situation, you are a good candidate for counseling.”
