Debt consolidation usually involves taking out one loan to pay off other debts or transferring credit-card balances to one card. People who consolidate debts are often trying to lower the overall interest rate they pay on credit cards and loans to make their monthly expenses more affordable. However, there are consolidation pitfalls to consider that could sink a person deeper into debt.
Home-Equity Loan
Homeowners who have a significant amount of equity in their homes may be able to consolidate their debts through a second mortgage or home equity line of credit. Home equity is determined by subtracting the balance owed on a mortgage from the appraised value of the home. Yet there are other important things to consider even if you have enough equity to pay off your debts. A consolidation loan that uses your home as collateral puts you at risk of losing your home if you can't repay the loan. An MSN Money article titled "Insider's Guide to Debt Consolidation" says people who think they may eventually file for bankruptcy should avoid home-equity loans because they usually can't be discharged through a bankruptcy.
401k Loan
Employees who participate in their employer's 401k plan may be able to borrow as much as half of the funds accumulated in their retirement accounts. Such loans are usually paid back over five years at a low interest rate, and the payments go back into an employee's account. One disadvantage of borrowing from a 401k comes into play if you leave or lose your job. In such cases, the balance of your loan can be treated as an account withdrawal, which includes tax payments and penalties associated with making an early withdrawal from a retirement account.
Credit Cards
Credit-card debt can be consolidated by transferring balances from other credit cards to one with a low interest rate and a high credit limit. Some companies may offer you a low interest rate for a limited time if you transfer other credit-card debt to one of their cards. One problem with using credit-card consolidation deals is that card issuers may periodically raise your interest rate, especially if you miss making a payment. High interest rates make it more difficult to pay off debt, and it ultimately could take years to pay off a consolidation credit card if you only make the minimum monthly payment.
Considerations
Consider whether your debt-consolidation options allow you to pay less than you're already paying on loans and credit cards before you agree to a consolidation offer. Current credit problems may prevent you from getting low-interest offers for consolidation loans and credit cards. Compare your current interest rates with the rates and fees you would need to pay on consolidation offers to determine if debt consolidation will help you lower your monthly expenses.
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