You may be considering debt consolidation but, frankly, not know a whole lot about it. The fact is debt consolidation is a great way to help navigate yourself out of debt problems—for some people, in some circumstances. To find out if debt consolidation might be for you, you need to know the basics.

First of all, debt consolidation is different than debt relief and it’s different than bankruptcy. Bankruptcy is a legal action that wipes out your debt (and ruins your credit). Debt relief is an organized approach to working with your creditors to get them to settle your debts for less than you actually owe them. Neither one of those things is debt consolidation.

Debt consolidation involves finding some sort of vehicle (loan, refinancing a mortgage, line of credit) which you use to re-arrange your debt. The idea is that if you owe $50,000 in 18 smaller debts (for example, a student loan, some credit cards, an in-store finance plan for a computer, etc.), you borrow $50,000 to pay off the loans. That solves the problem of 18 small debts, but at a price. Now you have one jumbo loan to pay off. But if you do debt consolidation wisely, your big loan can offer you better terms and a lower interest rate (overall) than your collection of small loans.

If you get a debt consolidation loan (which may be a normal loan or may be a line of credit), they come in two main flavors: secured and unsecured. A secured loan is “secured” by some sort of collateral. You agree when you sign the loan that if you do not pay, the creditor can seize your assets. The classic secured loan is a mortgage on a house. If you have a mortgage, you have agreed in a legal document that  if you fail to pay according to the terms of the mortgage, the lender can foreclose on the house, meaning that they take over ownership.

You can also secure loans with bank accounts, brokerage accounts, and other forms of property. The beauty of a secured loan is that they are pretty easy to get and you can often get a low interest rate. After all, the risk is pretty low for the lender. Either you pay (lender wins) or you default and he gets your stuff (lender wins). Most lenders prefer to get your money rather than your property, but either way, they have security.

A loan is unsecured when the lender has no such collateral. In fact, the lender really does not have any recourse if you don’t pay him back, other than the usual avenues of collection agencies, legal action, and putting a black mark on your credit. The most common unsecured loan is a credit card.

If your debt consolidation program involves a loan, find out from your lender whether it is “secured” or “unsecured.” If you don’t own much property or have anything of value, your loan will be “unsecured.” Know that interest rates are higher for unsecured loan and people with little or no credit history or bad credit may not qualify for them.

If you own a house, your debt consolidation representative will probably talk to you about two good approaches to debt consolidation. One is called a “refinance” which involves refinancing your existing mortgage. You basically go back to the original lender or find a new lender and get a new mortgage. This can be particularly beneficial if you can refinance your loan at a lower interest rate (that is, your original mortgage has a higher interest rate than you can get today).

When talking to a debt consolidation expert about refinancing, you need to find out what kind of terms you’re getting on your new mortgage (interest rate, how many years you’ll be paying it off, terms of the mortgage) and what your new monthly payment is. You’ll end up with some money in your hand. That’s the money you use to pay off your debts. You are left with just a new mortgage. If things work out relatively well, your new mortgage payment will be lower than the sum of your old mortgage payment plus the debts you paid off. The result: one payment, total reduction in monthly outflow, no harm to your good name (that is, your credit report is unblemished).

A refinancing deal on the first mortgage of a house can often get you the best interest rate and the best overall arrangement of any debt consolidation option. The downside is not everyone qualifies for this (you need a house, first of all) and the other potential downside is that it tends to “hide” your debt. Let’s say you need to pay off $50,000 in debts. So you refinance your house and end up with $50,000 in cash. Your new mortgage is a 30-year mortgage at 7% and that extra $50,000 really isn’t all that noticeable because you’re paying it off over three decades and your new interest rate is a bit lower than your original loan.

If you end up refinancing (particularly if you can re-arrange your debt very well), you need to be very careful not to just go out and get more debt.

Some refinancing options will have you signing up for an adjustable rate mortgage. This is a mortgage whose interest rate is based on prevailing market trends. If the rate goes up, you pay more interest; if the rate goes down, you pay less. There should be caps or maximums and minimums on these interest rates, and you need to know them. Sometimes you can get a pretty good deal on an adjustable rate loan, but beware; that rate can change. As a general rule, lenders like adjustable rate mortgages when interest rates are low because it still gives them a chance to get higher interest at some point in the future. When the prevailing interest rate is already pretty high, most lenders are more eager to lock you into a fixed rate loan so that they can get the higher interest rate for the full thirty years.

Ask also about other mortgage options, if they might work for you. For instance, you can get mortgages that can be paid over 10, 15, or 20 years instead of the usual 30.

If you have a mortgage and pretty decent credit, you can also do some refinancing shopping. You may have more options than you realize! Start with your current lender, since that can help you reduce paperwork but don’t be afraid to look at other mortgage companies. A mortgage broker is a person who works with many mortgage lenders; a broker can give you a good overview of refinancing deals. Use the web and ask somebody at your bank, too.

If you use this as a chance to clean up your act, start saving money, paying off your bills, getting your credit back in order, and working on a budget, this kind of debt consolidation is the best thing going. And if your debt happened because your family suffered a medical catastrophe or endured some emergency, it can be the most sensible way out. The danger with refinancing is that you forget that you’re paying for your debts over 30 years. (And if your debt includes payments on the sofa in your living room, the running shoes in your closet, and the vacation you just took to Europe, that means you will not have paid them off for 30 years! That sofa is going to be decades in the dump before you pay it off!)

So don’t try to go the refinancing debt consolidation route without working with a certified credit counselor and having a game plan (and some discipline). It’s one of the best ways out of debt, but it’s also one of the easiest forms of debt consolidation to come undone.

Another approach to debt consolidation involves a home equity loan. You can only qualify for a home equity loan if you own a home that is worth significantly more than you owe on it. For instance, if you just bought a $180,000 house with zero down and property values have dipped slightly since you took ownership, you have virtually no equity. You owe pretty much what the house is worth.

But let’s say you bought a $180,000 house ten years ago with a decent down payment and, for this example, let’s say you are holding a mortgage on that property for $140,000. Now let’s say that the housing market in your area has appreciated to the point that, even conservatively estimated, your house is worth about $240,000 if you were to put it up for sale. Since the fair value of your house is $240,000 and you still owe $140,000 on it, your “equity” is $100,000. Equity increases if property value goes up or if you pay the mortgage down, and it really jumps when both happen.

Some debt consolidation organizations will lend you money based on the equity in your home. This is a form of secured loan and it does not involve having to refinance your mortgage. It’s a separate loan.

When approaching debt consolidation, first of all, check out your options online and in person. Don’t be afraid to start asking questions. Most rich people ask financial questions of financial people all of the time! If you have a bank you like, ask to talk to somebody at your bank about debt consolidation. You should absolutely seek out a certified credit counselor. You can also talk to mortgage lenders and debt consolidation companies.

Don't try to figure out all of this stuff by yourself; there's no enough time for you to become the kind of expert you need! Take advantage of the pros. They're all over.

Make sure you understand the terms of any loans or plans these people suggest. Ask what the payments will be, how long they will last, and what the interest rates are. Ask if loans are secured or unsecured. Find out any special terms. Be sure you understand what, if anything, might affect your credit report.

Last but not least, ask yourself if you’re really ready to get control of your finances. If you consolidate your debts but just go out and make more debts, you’ll not be any better off next year than you are now. In fact, you may dig yourself in deeper. You should only try debt consolidation when you’re serious.

< back to Article Bank >