Risks of Debt Consolidation, Types of Debt Consolidation Loans, Pros & Cons & Zero Percent Debt Consolidation Loans

Over the last decade, we have seen very low interest rates that entice many consumers to take on many different forms of debt consolidation loans (see below) to pay off their existing debt. These types of debt consolidation loans range from Home Equity Lines of credit to Zero Percent Credit Card debt etc. The goal of these debt consolidation loans is to take multiple monthly payments that have high interest rates into 1 low monthly payment with a lower interest rate. It doesn't get any simpler than this huh? Watch out! What you're doing by taking out a debt consolidation loan is a temporary quick fix to your debt problems, you are not treating the CAUSE of the debt; you are merely working on relieving the symptoms.

To prove the above point, we interviewed Chris Viale, GM at Cambridge Credit Corp. in Massachusetts, USA. He says 70% of American citizens who take out home equity or debt consolidation loans to pay off their existing credit card debt end up with similar debt loads (if not higher) almost within 2 years! By taking out 1 more loan together with the tons of debts you already owe, you are merely adding "more fire to the burning fuel" (Chris Viale). What's even worse, most debt consolidation loans that are advertised out there on the market are meant for people with good credit history and a good credit score. Thus, if you have a huge debt load, this means your credit score will be lower and you most likely will not qualify for these low interest debt consolidation loans. Below, we will describe a few types of Debt Consolidation Loans that consumers can take out, their pros and cons and how exactly they work.

Video: Suze Orman - How to Settle Debt on Your Own

1) Home Equity Line of Credit

We have written a detailed review of home equity lines of credit here. The definition is:

A home equity line of credit is a line of credit borrowed with your home as collateral. Therefore, if you fail to make payments on the borrowed credit amount, you will forfeit your home as it has been pledged as collateral. Because your home is probably the biggest asset you will ever own, most people use a home equity line of credit to pay for large education bills, home improvement costs and unexpected big medical bills. A home equity line of credit is not used for your day to day living expenses, typically, as it could jeopardize your home ownership.

debt consolidation risks

To add to the definition, a home equity line of credit can also be used to take out 1 bigger debt consolidation loan to pay off large credit card debt balances. The biggest risk to this is that you could literally lose the biggest asset you ever own, your home! Diane Giarratano, Educational Director at Garden State Consumer Credit Counseling in New Jersey quotes, "Some hardship occurs and now they have double the debt and if it's secured by their home, they could lose it."

The advantage of taking out a home equity line of credit to consolidate debts is that the interest you pay on these loans is tax deductible. Of course, tax breaks are always a nice thing! If you apply for a home equity line of credit at any bank, they will determine the total amount you can borrow taking into account the value of your home, what % of your home you own (and what mortgage you have left to pay off). Diane Giarratano, Educational Director at Garden State Consumer Credit Counseling in New Jersey says, "Banks will tell you how much you can borrow. That doesn't mean you should borrow the total amount, but that's what people do."

2) Zero Percent Credit Card

A zero percent credit card (0%) debt consolidation option is available to people who do not own their own homes and cannot take out a home equity line of credit. Generally, a 0% credit card is available to people who have a good credit score and good credit history. So this option is not for you if you have a bad credit history. What exactly is a 0% credit card? A 0% Credit card is a card that carries 0% interest (you will virtually pay NO interest) for a maximum of 1 year. In this 1 year, you can take full advantage of this feature by paying off as much of the Debt as you can possibly can.

debt consolidation

For example, consider the following scenario: John owes Credit Card debt of $20,000. The Annual Percentage Rate (APR) on this debt is 18%. Using common debt consolidation calculators, we derive the following amortization schedule of interest & original principal debt payments. If John makes monthly payments of $600, he will pay $300 in Interest charges in the 1st month. Only $300 out of the $600 debt payment will go towards paying off the $20,000 debt. After making 10 payments of $600 each, John will have paid $3210.82 towards the Original Principal and $2789.18 in Interest Charges.

Month

Payment

Interest Paid

Principal Paid

Remaining Balance

1

$600

$300

$300

$19,700.00

2

$600

$295.50

$304.50

$19,395.50

3

$600

$290.93

$309.07

$19,086.43

4

$600

$286.30

$313.70

$18,772.73

5

$600

$281.59

$318.41

$18,454.32

6

$600

$276.81

$323.19

18,131.13

7

$600

$271.97

$328.03

17,803.10

8

$600

$267.05

$332.95

17,470.15

9

$600

$262.05

$337.95

17,132.20

10

$600

$256.98

$343.02

16,789.18

Totals:

$6000

$2789.18

$3210.82

 

However, if John had taken out a Zero % Credit Card, his amortization schedule would like this. As you can see, after making monthly payments of $600, John will have paid $600 towards the original principal of his debt, and 0$ in Interest charges! If his interest rate was 18%, at the end of 10 months, he would still have a remaining balance of $16,789.18. However, if his interest rate was 0%, he would reduce his debt to a low $14,000 in just 10 months! See how a 0% credit card can really cut the deal?

Video: Debt Consolidation Can Lower Your Debt

Month

Payment

Interest Paid

Principal Paid

Remaining Balance

1

$600

$0

$600

$19,400

2

$600

$0

$600

$18,800

3

$600

$0

$600

$18,200

4

$600

$0

$600

$17,600

5

$600

$0

$600

$17,000

6

$600

$0

$600

$16,400

7

$600

$0

$600

$15,800

8

$600

$0

$600

$15,200

9

$600

$0

$600

$14,600

10

$600

$0

$600

$14,000

Here's a few pitfalls that could get you in trouble if you take out a 0% credit card:

  • 0% credit card is only offered to people with a good credit score and good history. Also, a 0% credit card can only be offered for a limited period of time, so you have to 100% advantage of the feature!
  • If you make only the minimum monthly payments required on your debt load even after you have a 0% credit card, forget it, it's not working!
  • The two above amortization schedules we presented take into account that you will NOT be tacking on any more debt to these credit cards.

3) Debt Consolidation Loan

Debt consolidation loans offers are spammed into our inboxes every single day. The advantage of taking one out is that a debt consolidation loan will take 20 of your different credit card lenders, combine them all into 1 single monthly payment with a lower overall interest rate. At least, that's the theory. Before you take out a debt consolidation loan, verify the following things:

  • Read the fine print of your loan agreement to see whether the savings from the loan really exist. Add up all the closing & financing costs of the debt consolidation loan and determine if the total payments you will be making are really below what your original payments are. If not, avoid taking out that loan. Use the Calculators - Do It Yourself Debt Consolidation Section to help you out in this.
  • Check the overall interest rate you are getting is actually lower than your current interest rates.
  • Check if the lender is allowed to bump up the interest rate if the loan is unsecured (meaning there is NO collateral such as your house or your boat attached to it).
  • Credit Unions are more lenient in offering debt consolidation loans than banks, so try them out first.
  • Learn what to watch out for when borrowing money.