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Debt consolidation

Debt consolidation entails taking out one loan to pay off many others. This is often done to secure a lower interest rate, secure a fixed interest rate or for the convenience of servicing only one loan.

Debt consolidation can simply be from a number of unsecured loans into another unsecured loan, but more often it involves a secured loan against an asset that serves as collateral, which is most commonly a house (in this case a mortgage is secured against the house.) The collateralization of the loan allows a lower interest rate than without it, because by collateralizing, the asset owner agrees to allow the forced sale (foreclosure) of the asset to pay back the loan. The risk to the lender is reduced so the interest rate offered is lower.

Sometimes, debt consolidation companies can discount the amount of the loan. When the debtor is in danger of bankruptcy, the debt consolidator will buy the loan at a discount. A prudent debtor can shop around for consolidators who will pass along some of the savings. Consolidation can affect the ability of the debtor to discharge debts in bankruptcy, so the decision to consolidate must be weighed carefully.

Debt consolidation is often advisable in theory when someone is paying credit card debt. Credit cards can carry a much larger interest rate than even an unsecured loan from a bank. Debtors with property such as a home or car may get a lower rate through a secured loan using their property as collateral. Then the total interest and the total cash flow paid towards the debt is lower allowing the debt to be paid off sooner, incurring less interest. In practice, many people are in credit card debt because they spend more than their income. If that habit continues, the consolidation will not benefit them much because they will simply increase their credit card balances again.

Because of the theoretical advantage that debt consolidation offers a consumer that has high interest debt balances, companies can take advantage of that benefit of refinancing to charge very high fees in the debt consolidation loan. Sometimes these fees are near the state maximum for mortgage fees. In addition, some unscrupulous companies will knowingly wait until a client has backed themselves into a corner and must refinance in order to consolidate and pay off bills that they are behind on the payments. If the client does not refinance they may lose their house, so they are willing to pay any allowable fee to complete the debt consolidation. In some cases the situation is that the client does not have enough time to shop for another lender with lower fees and may not even be fully aware of them. This practice is known as predatory lending. Certainly many, if not most, debt consolidation transactions do not involve predatory lending.

Concerns of consolidation

In recent years, reports in the media [1] have raised concerns about the use of consolidation loans. The worry is that many people are tempted to consolidate unsecured debt into secured debt, usually secured against their home. Although the monthly payments can often be lower, the total amount repaid is often significantly higher due to the long period of the loan. In some circumstances, snowballing debt may be a better solution.

There are other alternatives to a debt consolidation loan, where unsecured debt is not "shifted" to secured debt, but is eliminated through a settlement or payment plan. Debt consolidation can be confusing for many people, so it is helpful to learn about all of your options, and sometimes with the help of an advisor.

Equity Loan Explanation

If you own a home, you can borrow against the equity, the difference between your home's appraised (fair market) value and your outstanding mortgage balance, that you have in your home.

For example, you purchased a home at $150,000 five years ago. When you secured the original mortgage, you paid $15,000 as the down payment and secured a mortgage of $135,000. In the five years you've owned your home, you've repaid, $10,000 toward the principal of the original mortgage and the home has increased in value to $170,000. To calculate your equity add the beginning equity, plus the amount of principal paid off, plus the increase in property value or:
$15,000 + $10,000 + $20,000 = $45,000

Your equity in your home is $45,000.

There are two types of equity loans available. A "term" loan is a single lump sum, that is paid back through regular monthly payments over a period of time. These second mortgages are usually for a shorter term than the original mortgage and generally carry a fixed interest rate.

The second type of home equity loan works more like a credit card. With a Home Equity Line Of Credit, a lump sum is not given. Instead, a credit line is opened. If you have $45,000 equity in your home, you might be given a $45,000 credit line. This type of Home Equity Loan is more flexible than a term loan but the interest rate usually varies as does the payment. These lines of credit carry a time limit set by the lender and will require that the amount be completely paid off as that time limit comes to an end.

When deciding which equity loan is right for you, take into account the purpose of the money. Many people use Home Equity loans for home improvements, debt consolidation, or one time big purchases. No matter what the purpose of your home equity loan, be sure to ask questions and establish trust in your lender.


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