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TO CONSOLIDATE OR NOT TO CONSOLIDATE

Fortunately Hamlet did not have to ponder the consequences of mounting unsecured debt, coupled with the prospect of limited income with which to maintain those debt obligations.  However, many homeowners are faced with this issue, and may consider using untapped equity in their house to obtain a consolidation loan to pay off those debts.  A consolidation loan can take many forms.  It may be a traditional “cash out” refinance where the original mortgage is refinanced and additional money is taken out to pay off unsecured debt.  It may be a second mortgage that is obtained with the primary purpose of paying off unsecured debt, with a specific loan term of 5, 10 or 15 years.  Probably the most available option for creditworthy homeowners is the home equity line of credit (“heloc”), which is more like a traditional revolving credit account, in that it has no fixed term and no fixed monthly payment, other than a specified minimum payment based upon the interest rate and balance.  For purposes of this article, I will refer to all of these as consolidation loans.

The first issue to consider is the type and amount of debt that is of concern to the homeowner.  The attraction of consolidation loans is that they consolidate multiple unsecured debts – usually credit cards – into one lower payment with a lower interest rate.  Because consolidation loans are secured against the homeowner’s residence, they are able to offer a lower interest rate.  Additionally, while credit card interest is not deductible for income tax purposes, mortgage interest is deductible.  In a situation where the accumulation of credit card interest is the main concern, a consolidation loan would offer a more manageable monthly payment.  However, if the debt to be consolidated is non-interest accruing – such as medical debt – it may not make any sense to substitute an interest-bearing consolidation loan to pay it off.

Even if a consolidation loan would yield a benefit to the homeowner in the form of reduced interest and a lower monthly payment, that does not automatically mean that is a good idea.  The reason that the consolidation can offer more favorable terms, is that it is secured by the homeowner’s residence.  Unlike a credit card company which would have to pursue its debt through the civil courts, in a lengthy and time-consuming process, a consolidation loan creditor can foreclose on the collateral in the event of default.  As a result, the risk to the homeowner in the event of default on a consolidation loan is much greater than the consequences of a credit card default.  This is not a risk that should be taken lightly, and too often lenders will gloss over this possibility when discussing terms with homeowners.

Assuming that a consolidation loan will ease the homeowner’s burden, and that the full risk of default on a consolidation loan is understood, there are still additional factors to be considered before taking the next step to obtain the loan.  A common mistake by consumers is to obtain a loan to pay off a portion of their unsecured debt.  While some credit card (and other high interest) debt may be eliminated, the homeowner has not entirely eliminated the problem of high-interest debt.  In this case, the homeowner now has a consolidation loan payment, but still has some remaining credit card debt obligations which could still spiral out of control.  Another mistake is to pay off the credit card debt in full through a consolidation loan, but then continue to use the credit cards and generate more high-interest debt which may not be eligible for consolidation.

Another factor to consider is the expected duration of remaining in the residence.  Accumulating additional debt against your residence could impair your ability to sell the house in the future, as a consolidation loan would have to be satisfied from the sale of the residence.  In some cases, the loan may actually put the homeowner “underwater”, meaning that the amount of debt secured by the house exceeds its value.  With the present slowdown in the housing market, this is a vital consideration for a potential borrower who may be expecting to sell the home or relocated in the next 5 years.  Likewise, a homeowner needs to evaluate their expected future earnings and determine whether or not they will be able to maintain the payments on the consolidation loan.  For instance, an individual who is 60 years of age and scheduled to retire at age 65 would probably not want to obtain a 15 year second mortgage or heloc with a repayment term which may exceed their employment.  While their income during employment may be more than sufficient to make the payment on the loan consolidation, a reduction in employment after retirement could impair their ability to make the payment, causing them to lose their home.  Unfortunately, this is becoming all too common as older homeowners are the most likely to have accumulated enough equity in their home to be eligible for a consolidation loan.

 

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