Real Life Debt Consolidation Loan Example
You have a gas card with a balance of $400 at 18%, a Master Card with $6000 at 14%, a VISA with $8000 at 15.9%, and a department store card with $6500 at 22%. You owe a total of $20,900. Your local bank charges 12% interest for equity loans and has an $800 loan origination fee. Your strategy might be to borrow $20,900 with an equity loan from the bank to payoff all your balances, and close out the accounts. Now you’ll still owe $20,900 but at a lower APR of 12%. Also, at the end of the year, you are usually allowed to write-off the interest you paid, effectively making your APR even lower. Most equity loans are 15 year notes, so try to send in extra principal every month to accelerate that payoff time. Make sure your bank allows pre payment and extra principal payments. Online sites usually have lower rates than banks. Now you are paying one check every month to pay off your credit card debt.
But supposing you only have $7500 equity in your house. How can you consolidate all your debt with $7500? You can’t, you’ll have to choose which accounts to payoff. The department store and gas card have the highest APR, so shoot for those. You’ll need to borrow $6900 with your equity loan. There is no reason to borrow more, and you should not either. Sure you would like to buy down some of the interest with your equity, but if you don’t have enough to pay it off and close the account, then there is a very high risk that you’ll just run the balance back up again. Some accounts you can close, then just continue to pay them off, then you’re OK using the remainder of your equity balance to buy down whatever you can on the balance. But we cannot stress the importance enough that you must not let your balances go back up. Consolidation loans and equity loans are potentially dangerous in the wrong hands because you are adding another channel of credit, so use it wisely, and always be fully aware of what you are doing.Home Equity Loans:
Home equity loans are used by many to consolidate debt. Borrowers take out a home equity loan to payoff their credit cards, and then close out those accounts. Now they just pay one bank, one monthly home equity loan payment with a lower APR than their credit card accounts. For example, typical credit card and department store card interest rates are 18-22%. But home equity loan APR can be under 10%, and many might not even have any fees. Home equity loans will cut the interest portion of your payment in half, which has the effect of paying off your principal much faster than credit cards. One benefit of home equity loans is you usually get to write the interest off your taxes, making the APR on the loan effectively lower. You cannot write off interest if the loan is in excess of the value of you home.
When not to Borrow
Some unscrupulous lenders flood your mailbox with offers. “We’ll lend you up to 125% of the value of your home!” Wow, you just struck oil! This is very dangerous oil however, because if you default on the loan, not only do you lose your house, but you still owe the other 25%. Not only that, you can’t write off the interest if you borrow more than the house is worth. The lenders who offer these risky loans are in it only for their own greed. Because they are writing higher loan values, they group them together and sell the portfolio to institutional investors, now their hands are washed of it and so what if you default, they made their money and moved on to the next group of suckers. Oops! I meant to say borrowers.
Any bank with a conscience will only lend you up to 80% of the equity in your home. They send out an appraiser to get an accurate value of your house, then they determine how much equity you have in the house, and lend you up to 80% of that value. This is the safest way to do a home equity loan. You must evaluate whether an equity loan makes sense for your financial situation. You have to weigh the APR, and the loan fees if any against the APR of the debt you are trying to eliminate. Make sure you close out any accounts that you are trying to pay off. Borrow only enough to payoff the accounts in full. You might not be able to borrow enough to pay off all your debts, so don’t straddle the cash across all your accounts. Use it to payoff your top rate cards, and close them out.