Consumer credit card balances are rising, caused in part by an ailing economy that has motivated people to seek temporary financial relief, but usually at a high cost.
One possible option for balancing the budget is a debt consolidation loan, which combines multiple high interest debts into one low rate payment. Sounds simple enough, but you have to be a homeowner, and you need to have home equity and decent credit.
A debt consolidation loan is also known as a cash out refinance or home equity loan. Unsecured credit cards, or other debts, are paid off using the equity in a home. A low fixed rate loan reduces the monthly payment, and because a debt consolidation loan is fully amortized, the debt will be gone at the end of the loan term. Also, converting debts to a secured home loan may save money because of possible tax deductible interest.
Another lesser known benefit of a debt consolidation loan is the elimination of daily compounded interest on credit cards. More interest charges accumulate on a compounded interest loan as opposed to a simple interest loan. Paying interest on the interest charges could be the end result if only the minimum payments are made.
Look at a simple example: An average rate of 15% on credit cards with a combined balance of $40,000 could have a monthly payment of about $560, over a 15 year term. A debt consolidation loan with the same balance at 8% could have a payment of about $382 over the same term. A lower rate would of course result in more savings. Also, the loan could be paid off in about half the time by applying the monthly savings to the payments.
A debt consolidation loan may involve a refinance, so it should be noted that some lenders have an underwriting guideline called seasoning. Cash out can be limited under this guideline based on when home equity was taken out. Restrictions may apply if there was a cash out refinance done within the last 6 months to 1 year. Usually, this guideline applies if the new loan is over 75% of value. FHA loans offer more flexibility, with cash out up to 95% loan to value.
The seasoning rule on a conventional debt consolidation loan may not be limited only to a previous cash out refinance. If there was a home equity loan or line of credit taken out within the last 6 months to 1 year before refinancing, the new loan could also be subject to cash out limitations.
