Debt consolidation involves paying off all, or some, of your debts with a larger new loan. You can then pay the loan off so you no longer owe the money. However, the effect is the same, since you previously had a number of smaller loans and credit cards and now you have one loan and one payment. A larger consolidation loan is usually secured against an asset, most commonly your home.
Qualifications
Your home must have equity, or be worth more than the mortgage plus consolidation loan. Some lenders require a 20 percent equity to loan value, while others demand more than 20 percent. If you don't have at least 20 percent equity, the consolidation loan probably won't be approved. You must have a solid repayment history on your mortgage and have a good credit score. The better your credit score, the lower the interest rate on the consolidation loan. If you've missed payments, the probability is that you won't be approved, or if you are, the interest rate will be higher.
Impact on Credit Score
Your credit scores won't be affected negatively if you use the proceeds of the consolidation loan to pay off debts and you don't build up the balances again. The problem is that most people either start using the cards again or immediately close the old accounts. Either action could have a negative impact on your credit scores. Closing the accounts decreases the ratio of used credit to available credit, which is perceived as negative by the credit bureaus. Using the accounts without paying off the balance every month eventually puts you in a worse position than before the consolidation.
Interest Rates
The interest rate you pay for a consolidation loan is based on the equity in your home, your credit rating, your income and job stability and whether the loan is a refinancing, a new mortgage loan or a second mortgage. Second mortgages have a higher interest rate than first mortgages.
Advantages
The consolidation loan most likely will have a longer term and lower interest rate than the smaller loans. That means your monthly payment will be less, giving you more money each month. You only pay one payment, rather than a payment on each one of your credit cards and personal loans. That's less work for you.
Disadvantages
Most consolidation loans are either a second mortgage on your home or a result of refinancing your home. If you miss a payment, your house is at risk through the lender foreclosing on the mortgage. If the real estate values in your neighbor fall, you may have a difficult time selling your home, especially if you owe more on the home than its market value.
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