Debt Consolidation – Good or Bad?

It seems that everywhere you look these days you can find ads trying to entice people to consolidate debts.

The usual catch-cry goes something like this: “Put all your personal debt (car loans, credit cards etc) into the home mortgage AND cut your repayments in half!”

Let me tell you – those ads are RIGHT. You really could cut your monthly repayments in half. Imagine how much extra money you’re going to have in your pocket each month if you just called a consolidation company or lender and let them fix it all up. What those companies DON’T tell you is that when you consolidate you could end up paying WAY more money in the long run for something you probably don’t even own any more.

How They Do It

Let’s look at the sales-method calculations used by consolidation companies and see how they really CAN halve your monthly repayments.

Home Mortgage: $120,000 at 7.5% over 30 years = $839.06 per month
Car Loan: $15,000 at 10.25% over 5 years = $320.55 per month
Credit Card: $5,000 limit at 18.25% = $80 per month (interest only plus small nominal payment)

Your total monthly expense for the example above is: $1,239.61 per month.

Now, your consolidation company would tell you that if you put your personal debts into your home mortgage and refinanced them, you could cut your monthly payments dramatically!

If you refinanced your home mortgage to include your personal debts, then your NEW loan amount would be $138,000 ($120,000 + $12,000 + $5,000 + $1,000 closing costs = $138,000)

New repayments for a loan of $138,000 at 6.5% over 30 years = $872.25 per month
That’s a potential saving of $367.36 every month. Wow! An extra $367 in your pocket every month. Imagine what you could do with that! No wonder those debt consolidation ads are everywhere you look.

Okay – we didn’t cut your repayments in half, but you can be sure that if I’d used bigger numbers and higher interest rates, I could have worked out a way to show you a GREAT sales pitch for consolidating your debts.

How We See It

The reality of the situation is a little different…

You see, if you continued to pay your $15,000 car loan at $320.55 per month for 5 years, then at the end of 5 years, you would own that car.

Paying $320.55 per month x 60 months (5 years) = You would have paid $19,233 for that car over 5 years.

But if you consolidate that $15,000 into your home mortgage, it will take you up to 30 years to pay off the same car. Let’s see what happens if I work out the cost now…

$15,000 at 6.5% over 30 years = $94.81 per month x 360 months (30 years) = $34,131.60 for the same car!
Would you pay $34,131.60 for a car you know should only have cost $15,000? I know I wouldn’t!

I’m guessing that in 30 years time you won’t even have the same car any more, so you’ll probably be paying off a different car (or two) by then AS WELL.

The same principle applies to your credit card. Will you even remember what you bought for $5,000 in 30 years time? Not likely?

Before you consolidate your debts onto your home mortgage, ask yourself if you couldn’t perhaps budget your current income just a little differently to avoid having to get into a situation that just keeps you in debt even longer than you already will be!

No equity loan

A no equity loan is known in the real estate industry as a “high loan-to-value (LTV) loan.” These are also known as 125 second mortgages, meaning that the borrower can obtain a loan putting his/her indebtedness on the house at up to 125% of the home’s value. It is a home equity loan for homeowners with no equity – a hybrid loan that is secured, but isn’t. A no equity loan is a high-risk venture for both borrower and lender, in the sense that everything has to go right in order for the loan to be repaid and the homeowner to get out of a cash-strapped situation.

No equity loans are not cheap. The interest rates on are extraordinarily high. They typically run two to six percentage points more than the rates for traditional home-equity loans – you can expect an interest rate in double digits. The fees for no equity loans are also going to be higher than for traditional loans. It is quite possible that a no equity loan will cause the mortgage insurance requirement to activate again, if it is not already present.

In the case of the 125 no equity loans, only a portion of the interest rate will be deductible. The IRS says that you can deduct interest payments on primary home debt equal to 100% of the home’s value. Any debt secured by the home beyond its value does not qualify for the tax deduction. It’s possible that your no equity loan won’t carry the tax deduction which is applied to both first and second mortgages that are secured by home equity.

A no equity loan is also going to limit your options with regard to mobility. If you take a new job in another state, you are going to have to sell a house that you will still owe money on after the sale. That means coming up with the cash balance to make the lender whole, in order to complete the transaction. People who are desperate enough to consider a no equity loan aren’t likely to have that kind of cash in the savings account.

The no equity loan is usually recourse for those people with serious cash flow problems. But defaulting on a no equity loan is different from falling behind in your credit card payments. In the case of the loan, you are in danger of losing your house. The fact that it is a “no equity” loan does not mean that the lender cannot come after the house, should you begin to miss payments.