Debt consolidation loans: How to make them work

Gina Pogol
The Mortgage Reports contributor

In this article:

Credit card debt is expensive. The monthly payments can keep you up at night. But you may be able to wrap those debts into one loan with a lower interest rate and payment.

  • Home equity financing is almost always cheaper because the debt is secured by your property
  • You should be able to significantly drop your interest rate and payment
  • However, there are pitfalls, and there are better solutions for many consumers

This article explains debt consolidation refinancing, its pros, cons and alternatives.

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Home loan versus credit card interest rates

If you have so much consumer debt that you’re only making minimum monthly payments, consolidating your accounts might be a better financial decision.

Loans secured by real estate, like cash-out refinances or home equity loans, tend to have the lowest interest rates — much lower than unsecured debt like credit cards.

For example, in 2018, the average credit card rate is about 17 percent, according to USA Today.  While home equity loans and cash-out refinances are closer to 5 percent.

Advantages of debt consolidation mortgages

There are several reasons that debt consolidation using home equity is so popular. They offer solid benefits in certain situations.

Low interest rates

As of October 2018, US News puts the average home equity loan interest rate at 4.82 percent. Home equity loans are secured by your property, just like the loan you used to purchase  it. Because the first mortgage takes priority if you end up in foreclosure, home equity loans are often called “second mortgages.”

Your other option for getting a lump sum of cash for debt consolidation is the cash-out refinance. You refinance your existing mortgage with a larger one, and use that extra money to pay off your high-interest debts. This is a good option if you can improve on the terms of your current mortgage.

Home equity loan tax deductions

In 2018, new tax laws have been batted around in Congress, and the current plan scraps the deduction for home equity interest when used for debt consolidation. According to the IRS,

“Under the new law, for example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not. ”

Reduced payment

Keep in mind that when you consolidate debt, there are two factors that reduce your payment – a lower interest rate, and a longer term.

Most refinance loans have 15 or 30-year terms, while home equity loan terms average 15 years.

The longer you stretch out payments, the lower your payments will be. The following is a monthly savings example.

  • Credit card balance of $15,000 at 15 percent: $346 per month
  • 15-year home equity loan at 4.93 percent: $123 per month

It takes longer to pay off the balance with a home equity loan, but a home loan could free up your budget in the short term dramatically.

Improved credit score

Lowering your “credit utilization ratio” helps your credit score. Utilization is the percentage of your credit card limits that you are using at any given time.

Paying off all of your unsecured debt drops your utilization to zero, while adding that amount to your home mortgage doesn’t hurt your credit score.

Verify your new rate (May 23rd, 2019)

Drawbacks: Mortgages for Debt Consolidation

Like all mortgage products, debt consolidation loans come with some trade-offs. Here they are.

High failure rate

About 80 percent of debt consolidation strategies fail, according to finance guru Dave Ramsey. But it is not the fault of the debt consolidation loan. It’s the failure of the borrower to reset and change the behaviors that led to debt problems in the first place.

The homeowner pays off and closes credit card accounts, just to re-open and charge up new balances. Consolidation home loans should be used as a one-time “clean-up” strategy, after lifestyle changes have taken place.

Increased interest expense

The longer repayment schedule for home loans can cause homeowners to pay more interest, even if the rate is lower.

For example, you repay your $15,000 in credit cards at $470 per month for 43 months. Total interest is $5,200. Or, you consolidate it with a 15-year home equity loan at 4.93 percent. That drops your monthly payment for the debt to $123. But extending the repayment to 15 years means the cost over the life of the loan increases to $7,140.

That’s not necessarily “bad” if it takes pressure off your monthly budget. But looking long term, it’s more expensive.

You can lessen the effect of the extended repayment and reap the benefit of the lower rate by paying your principal balance early. For example, if you pay $300 a month instead of $123 (still saving $170 a month), your interest cost falls to $1,825, and you pay your loan off in less than five years!

Not discharged in bankruptcy

Unsecured debts like credit card accounts can be discharged in a bankruptcy proceeding if you find you can no longer afford your payments.

However, if you pay off the accounts with a cash-out refinance or a home equity loan, those balances are now secured by your home. They can’t be discharged in bankruptcy without going through foreclosure.

When your accounts are unsecured and you experience financial problems, you have a lot more leverage over an unsecured creditor than you do a mortgage lender.

Debt consolidation mortgage the right way

Being aware of the potential pitfalls of debt consolidation can help you avoid them. Every one of the potential problems can be headed off by borrowing carefully.

  • Seek help to get spending under control
  • Make a higher-than-minimum payment on credit cards
  • Consider zero-interest transfers or personal loans as alternatives

There are several methods for getting debt under control. All, however, take time, knowledge and commitment.

What are today’s debt consolidation rates?

Homeowners with high debt might find that a debt consolidation loan is the best course of action. For them, low mortgage rates will assist in lowering monthly payments.

Get a quote for your debt consolidation refinance. A request can be completed in minutes, and you can have multiple written quotes in hours.

Verify your new rate (May 23rd, 2019)