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By: Christopher Way, Relationship Banker
You've heard the advertisement - consolidate your debts into one easy payment. But is it advantageous for you to do so? The first thing you need to do is examine the reasons why you might consider consolidating and then decide which alternative may be best for your personal situation.
Lower Interest Rates
If you've accumulated credit card debt and made a late payment, the credit card company has most likely increased your interest rate. In this case, you may consider transferring your high interest credit card debt to a credit card charging less interest. However, beware of low introductory rates. They are typically not locked in for a significant period of time and, after the initial period, the rates are likely to go up. This may be a fine alternative if you plan to pay off the card before the introductory period expires. But if that does not seem likely, you may want to pursue a different consolidation vehicle if the post-introductory period interest rate is higher than the present rate you are paying.
Obtaining an unsecured personal loan through a bank may be a better alternative. If you qualify, you may be able to borrow at a rate lower than you currently pay. However, unsecured loans may be difficult to obtain from a bank if you already have a lot of unsecured debt. A better option (and typically an easier loan to get approved) could be a home equity loan. The interest on a home equity loan is generally deductible on your income tax return as mortgage interest, subject to certain limitations, and the rates are likely to be lower than what you're paying on your credit cards.
If you're not a homeowner and are unsure if you will qualify for an unsecured loan from a bank, you might consider taking out a consolidation loan through a reputable finance company. However, be advised that the interest rate can sometimes be as high, or higher, than your credit card and other fees may be in connection with the loan. But because a consolidation loan would require monthly payments over a set period of time, such a loan might still be a better way to pay off your credit card debt.
Lower Monthly Payments
When consolidating debt into "one easy payment," the "easy" part refers not to writing one check, but paying a lower (and more affordable) amount each month towards your debt. The downside, though, is that the reduced payments mean you are likely paying less towards principal. Long-term, this could mean that you end up paying more interest. Your best bet is to pay a little extra each month, which will help reduce your principal balance over the long run.
What Will It Cost Me?
The cost of consolidating your debt is a factor that should not be ignored. If you get a home equity loan, you should have a clear understanding of what fees will be due for closing costs and what points you may have to pay. If you transfer balances from one card to another, find out what charges are involved first, including at what point, and at what level, any introductory rate might be adjusted after the introductory period. These costs should be factored into your decision. If the interest rates you currently pay and the rates you would pay under a consolidation loan do not differ significantly, the cost of consolidating could make the transaction a "wash."
Do I Have a Plan to Get Out of Debt?
One danger of consolidating debt into one reduced payment is that it may give you a false sense that you have control over your debt. What a relief not to have those credit card bills with huge payments rolling in every month! However, the temptation to begin accumulating credit card debt again may be hard to resist. If you consolidate your debt, you need to have the discipline to stop incurring more debt. Otherwise, you will end up worse off than before. In addition, if you default on the home equity loan - with your house standing as collateral - the result could be foreclosure.
Consolidation may be a good idea to improve your overall financial situation, but make sure you have a plan in place and stick to it. With time and discipline, you should be able to decrease your total debt and start saving more for the future.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.