Originally Published: February 13, 2013 9:45 p.m.
It is tempting to consolidate your debt (auto loans, credit cards, personal loans, etc.) with either a home equity loan or a credit card offering a low introductory interest rate. When it comes to debt consolidation, here are a few guidelines that will assist you in making an informed decision.
Consolidating your debt with a home equity loan is tempting since these loans generally have low interest rates and the interest is usually tax-deductible. However, equity in your home is an asset that should be treasured and protected. The decision to use it to consolidate debt should not be taken lightly.
A home equity loan is secured debt, meaning the loan is tied to an asset that is considered collateral for the debt - in this case, your home. When home equity loan payments are delinquent, the bank will foreclose on the home. On a regular car loan, the car is collateral and the bank repossesses it if payments are not made. This makes consolidating automobile debt with a home equity loan risky. If the car debt is consolidated with a home equity loan, the house is now securing the debt on the car, and the ownership of the house is at risk if you are unable to make the payments. Consolidating your credit card balances with a home equity loan is risky for the same reason. In fact, consolidating any debt with your home equity can put your home at risk, and is not generally a good option.
Now, let's focus on consolidating credit card debt. A good option for this can be combining your balances on high-interest rate credit cards with a new credit card that offers a low introductory interest rate. In contrast to a home equity loan, a credit card is unsecured debt, meaning it is not secured by collateral. When payments become delinquent, the credit card company will attempt to collect the debt, but they do not have the right to repossess property. (Be aware that although your purchases are safe from repossession, your credit rating is still ruined by delinquent payments.)
A typical incentive offered by a credit card company might be zero percent interest for 12 months, but this isn't a free offer. The customer must pay a "balance transfer fee" to the new company, which is usually 3 or 4 percent of the amount transferred. Consolidating debt to a credit card with a low interest rate is an option only if your credit rating is healthy, you have shown a consistent pattern of on-time credit card payments and there aren't excessive open lines of credit.
Before you decide to consolidate your credit card debt, calculate to be sure that the cumulative amount you will pay is favorable, and establish a disciplined debt payment plan. As an example, let's use a $15,000 credit card balance with a 14 percent interest rate and a $350 monthly payment. At the normal rate of payments, the debt will be paid off in 60 months and cost $5,915 in interest. If the debt were transferred to a new card with a 0 percent interest for 12 months and a 4 percent transfer fee, the debt would be extinguished in 43 months and cost $3,930 in interest and fees. (The interest rate increases to 14 percent after the 12-month introductory period). On paper, consolidation undeniably saves money.
Nevertheless, consolidating credit card debt has a dangerous side. With a zero balance on the old cards, they can be used again. The temptation of the available credit can be brutal. The old credit card accounts must be closed and consistent payments need to be made on the consolidated account in order to ensure a successful journey out of debt.
Debt generally doesn't accumulate in one day, so it won't disappear in one day. Consolidating debt can be a good financial move if you avoid using your home equity, if old credit card accounts are closed, and if discipline is established for the long haul of climbing out of debt. I encourage you to dream big and think of all that can be accomplished living a debt-free life. Your efforts will definitely be worth it.
Kara Rozendaal, a financial planner, wife and homeschool mother of three has lived in Prescott Valley for 15 years. Learn more ways to save at Kara's FREE class on Feb. 28, 6 to 8 p.m. at Trinity Christian School, Prescott. Register at www.PracticalSaver.com.