Debt consolidation is paying off multiple accounts with funds from a new loan. Many people pursue this option because it allows them to focus on only one, possibly lower, monthly payment. While it can help in some ways, one problem is that people often return to the same financial habits that got them into trouble in the first place.
How it Works
When a person chooses debt consolidation, he typically takes out a home-equity loan to pay off other accounts. Then the individual pays only one payment to the home-equity lender. In many cases, the interest rate and monthly payment are lower. If a person does not have a home, he could also get a personal loan or put all his debts on a single credit card, though this will be more expensive.
Longer Term
Even though you may get a lower payment using debt consolidation, it can actually cost you more in the long run. Your interest rate is much lower, but the term is likely much longer. With a home-equity loan, you might have to make payments for 20 years to pay off your debt. This adds up to thousands of extra dollars in interest over the life of the loan.
Build Up Debt Again
Another problem that many people have with debt consolidation is that they do not fix the root behavior that led to the debt in the first place. They simply put it in a different package and get a more affordable monthly payment. If they do not change their spending habits, they will most likely accumulate a large amount of debt again.
Tax Considerations
If you use your home equity to pay off your other debts, you can possibly get a tax deduction. When you itemize your tax deductions, you can deduct the interest that you pay on a home-equity loan. At the beginning of your loan term, the majority of your payment will be interest.
Risking Home
While using a home-equity loan can help you consolidate your debt, you are essentially risking your house with this process. If you default on the home-equity loan, the lender can foreclose on your home. With this type of debt consolidation, you are attaching unsecured debt like credit cards to a valuable piece of collateral. You have to be aware of the risk that comes with this decision, as it could end up in losing your home.
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