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How to Choose the Right Type Of Debt Consolidation

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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If you’re feeling buried by what you owe, debt consolidation could provide you with both immediate relief and a quicker path to debt-free.

Debt consolidation is the process of taking out a new loan and using that money to pay off your existing debt. It can help in a number of ways:

  • A lower interest rate could save you money and allow you to pay your debt off sooner
  • A longer repayment period could reduce your monthly payment
  • A single loan and single payment could be easier to manage than multiple loans

But debt consolidation isn’t without its potential pitfalls. First and foremost: Consolidating your debt doesn’t address the behavior that got you into trouble in the first place. If you’re in debt because of overspending, consolidating may actually exacerbate your problems by opening up new lines of credit that you can use to spend even more.

And every debt consolidation option has its own set of pros and cons that can make it a good fit or a bad one, depending on your circumstances.

This post explains all of those pros and cons. It should help you decide if debt consolidation is the right move for you, and, if so, which option is best.

Six Consolidation Options to Choose From

1. Credit card balance transfers

A credit card balance transfer is often the cheapest debt consolidation option, especially if you have excellent credit.

With this kind of transfer, you open a new credit card and transfer the balance on your existing card(s) to it. There is occasionally a small fee for the transfer, but if you have excellent credit, you can often complete the transfer for free and take advantage of 0 percent interest offers for anywhere from 12-21 months. None of the other debt consolidation options can match that interest rate.

There are some downsides, though:

  • You need a credit score of 700 or above to qualify for the best interest rate promotional periods.
  • Many cards charge fees of 3 to 5 percent on the amount that you transfer, which can eat into your savings.
  • Unless you cancel your old cards, you’re opening up additional borrowing capacity that can lead to even more credit card debt. Let’s put that another way: Now that you’ve paid off your old cards, you might be tempted to start using them again. (Don’t!)
  • If you don’t pay the loan back completely during the promotional period, your interest rate can subsequently soar. Some balance transfer cards also charge deferred interest, which can further increase the cost if you don’t pay your debt off in time.
  • This just isn’t for people with high levels of debt. Credit limits are relatively low compared with those tied to other debt consolidation options.

Given all of that, a credit card balance transfer is best for someone with excellent credit, relatively small amounts of debt and strong budgeting habits that will prevent them from adding to their burden by getting even further into debt.

Comparecards.com, also owned by LendingTree, tracks the best 0 percent balance transfer offers.

2. Home equity/HELOCs

Home equity loans and home equity lines of credit (HELOCs) allow you to tap into the equity you’ve built in your home for any number of reasons, including to pay off some or all of your other debt.

The biggest benefit of this approach is that interest rates are still near all-time lows, giving you the opportunity to significantly reduce the cost of your debt. You may even be able to deduct your interest payments for tax purposes.

But again, there are perils. Here are some of the downsides to using a HELOC/home equity loan for debt consolidation:

  • Upfront processing fees. You need to watch out for upfront costs, which can eat into or even completely negate the impact of lowering your interest rate. You can run the numbers yourself here.
  • Long loan terms. You also need to be careful about extending your loan term. You might be able to reduce your monthly payment that way, but if you extend it too far, you could end up paying more interest overall. Home equity loans typically have terms of five to 15 years, while home equity lines of credit typically have 10-to-20-year repayment periods.
  • You could lose your home. Finally, you need to understand that these loans are secured by your home. Fail to make timely payments, and you put that home in jeopardy. This is why, though the interest rates are lower than with most other debt consolidation options, there’s also added risk.

Home equity loans and HELOCs are generally best for people who have built up significant equity in their home, can get a loan with minimal upfront costs, and either don’t have excellent credit or need to consolidate more debt than is possible with a simple balance transfer.

You can ask your current mortgage provider about taking out a home equity loan or line of credit. Also, compare offers at MagnifyMoney’s parent company, LendingTree, here and here.

3. Personal loans

Personal loans are unsecured loans, typically with terms of two to seven years. Interest rates typically range from 5 to 36 percent, depending on your credit score and the amount you borrow.

The advantage of a personal loan over a credit card balance transfer is that it’s easier to qualify. While you typically need a credit score of 700 for a balance transfer, you can get a personal loan with a credit score as low as 580. You can also qualify for larger loan amounts than the typical balance transfer.

And the big advantage over a home equity loan or line of credit is that the loan is not secured by your house. This means you can’t lose your home if you have trouble paying back the debt. You can also apply for and obtain a personal loan very quickly, often at a lower cost than a home equity loan or line of credit.

The biggest disadvantage is that your interest rate will likely be higher than either of those options. And if your credit score is low, you may not find a better interest rate than what you already have.

Generally, a personal loan is best for someone with a credit score between 600 and 700 who either doesn’t have home equity or doesn’t want to borrow against his or her home.

You can shop around for a personal loan at LendingTree here. It’s important to compare offers to get the best deal possible.

4. Banks and credit unions

In addition to shopping for a personal loan online, you can contact your local banks or credit unions to see what types of loan options offer.

This is more time-consuming than applying online, and it can be harder to compare a variety of loan options. But it may lead to a better interest rate, especially if you already have a good relationship with a local bank.

One strategy you might try: Get quotes online using a service like LendingTree’s, then take those quotes to the bank or credit union and give it a chance to do better.

This strategy is best for anyone who already has a good and lengthy banking relationship, particularly with a credit union. But if you’re going the personal-loan route, it’s worth looking into in any case.

You can find credit unions in your area here.

5. Borrowing from family or friends

If you’re lucky enough to have family members or friends who have ample assets and are happy to help, this could be the easiest and cheapest debt consolidation option.

With no credit check, no upfront fees and relatively lenient interest rate policies, this might seem like the best of all worlds.

Even so, there are some things to watch out for.

First: A loan fundamentally changes your relationship with the person from whom you borrow. No matter what terms you’re on now or how much you love and trust this person, borrowing money introduces the potential for the relationship to sour in a hurry.

Consequently, if you do want to go this route, you need to do it the right way.

Eric Rosenberg, the chief executive of Money Mola, an app that lets friends and family track loans and calculate interest, suggests creating a contract that outlines each party’s responsibilities, how much money will be borrowed, the timeline for repayment, the payment frequency and the interest rate. He also suggests using a spreadsheet to keep track of the payments made and the balance due.

And Neal Frankle, a certified financial planner and the founder of Credit Pilgrim, suggests adhering to the current guidelines for Applicable Federal Rate (AFR), which as of this writing require a minimum interest of 1.27 to 2.5 percent, depending on the length of the loan. Otherwise, you may have to explain yourself to the IRS and the person lending you the money could be charged imputed interest and have to pay additional taxes.

If you have a family member or a friend who is both willing and able to lend you money, and if your credit isn’t strong enough to qualify favorably for one of the other options above, this could be a quick and inexpensive way to consolidate your debt.

6. Retirement accounts

Employer retirement plans like 401(k)s and 403(b)s often have provisions that allow you to borrow from the accumulated sums, with repayment of the loan going right back into your account.

And while you can’t borrow from an IRA, you can withdraw up to the amount you’ve contributed to a Roth IRA at any time without penalties or taxes, and you can withdraw money from a traditional IRA early if you’re willing to pay both taxes and a 10 percent penalty (with a few exceptions).

The biggest advantage of taking the money out of a retirement account is that there is no credit check. You can get the money quickly, no matter what your credit history looks like. And with a 401(k) or 403(b), you are also paying interest back to yourself rather than giving it to a lender.

Still, while there are situations in which borrowing from an employer plan can make sense, most financial experts agree that this should be considered a last-resort debt consolidation option.

One reason is simply this: Your current debt is already hindering your ability to save for the future, while taking money out of these accounts will only exacerbate the problem. Another is that tapping a retirement account now may increase the odds that it will happen again.

“I’d stay away from a 401(k) loan like the plague,” says Ryan McPherson. McPherson, based in Atlanta, Ga., is a certified financial planner and fee-only financial planner and the founder of Intelligent Worth. “With no underwriting process, and because you’re not securing it with your house, you’re more likely to do it again in the future.”

If you are in dire straits and cannot use any of the other strategies above, then borrowing or withdrawing from a retirement account may be the only consolidation option you have. Otherwise, you are likely to be better off going another route.

Things to consider before picking a debt consolidation strategy

With all these debt consolidation options at your disposal, how do you choose the right one for your situation? To be sure, it’s a key decision: The right option will make it easier for you to pay your obligations, and less likely that you’ll fall back into debt.

Here are the biggest variables you should consider before making the choice:

  1. Have you fixed the cause of the debt? Until you’ve addressed the root cause of your debt, how can any consolidation option help you get and stay out of debt?
  2. How much debt do you have? Smaller debts can be handled through any of these options. Larger debts might rule out balance transfers or borrowing from relatives or friends.
  3. What are your interest rates? You need to be able to compare your current interest rates with the interest rates you’re offered by the options above, if you want to know whether you’re getting a good deal.
  4. What is your credit score? Your score determines eligibility for various debt consolidation options, as well as the quality of the offers you’ll receive. You can check your credit score here.
  5. When do you want to be debt-free? Shorter repayment periods will cost less but require a higher monthly payment. Longer repayment periods will cost more but with a lower monthly payment. With this in mind, you need to decide both what you want and what you can afford.
  6. Do you have home equity? This determines whether a home equity loan or line of credit is an option. If it is, you should decide if you’re comfortable putting your home on the line.
  7. Do you have savings? Could you use some of your savings, outside of retirement accounts, to pay off some or all of your debt? That may allow you to avoid debt consolidation altogether and save yourself some money.

So … what’s the best consolidation strategy?

Unfortunately, there is no single answer to this tough question. The right answer for you depends the specifics of the situation.

Your job is to know what you currently owe and understand the pros and cons of each option we’ve outlined above. In this fashion, you can make an informed choice, one that’ll get you out of debt now and keep you out of it forever.

Matt Becker
Matt Becker |

Matt Becker is a writer at MagnifyMoney. You can email Matt at matt@magnifymoney.com

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Americans Are Going Deeper Into Debt As Banks Relax Lending Criteria

The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

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Today, Experian Decision Analytics released its report on consumer credit trends in the United States during the second quarter of 2015. The data shows a clear trend: Americans are borrowing more, and banks are relaxing credit criteria once again.

New credit lines issued by banks on credit cards have reached a post-crisis high. Auto loan originations have grown 16% over the last 12 months, and total auto balances have crossed the symbolic $1 trillion mark. Mortgage originations are up 50% since the trough of Q1 2014, and home equity originations are up more than 60% since 2014.  Growth is coming from familiar products, familiar FICO score and familiar states. Not surprisingly, states like Florida and California are leading the growth of home equity withdrawal, and near-prime is once again popular marketing territory.

Banks and credit unions are increasingly willing to offer credit to riskier borrowers. Credit card issuance to near-prime customers is up 7%. Non-prime auto loans are growing by more than 15%. After the credit crisis of 2008, banks had tightened credit significantly. Over the last 12 months, banks have started to grow aggressively in the near prime sector (borrowers with credit score of 601 – 660). In the last credit crisis, some of the worst credit loss performance came from near-prime borrowers. A huge bet is being made on consumers having “learned lessons,” from the previous crisis. Banks are willing to lend on the presumption that borrowers are more responsible now.

At the moment, delinquency and losses still look low and stable. But delinquency and losses should look good at this point in the credit cycle, because losses lag loan growth. Default performance today comes from the loans and credit limits that were issued in the past. As banks continue to offer credit to higher risk borrowers, it will take a few years before the true impact of the increased risk tolerance will be known. One thing is certain: delinquency and losses will definitely increase over time from current levels.

A lot has been written about the growth of marketplace lenders. Although marketplace lenders have been making a lot of noise, traditional banks continue to grow rapidly. And credit unions have quietly been growing their assets at an astonishing rate. In some respects, the credit unions are the opposite of marketplace lenders. They are light on technology and data. Yet they are rapidly increasing their exposure to the sub-prime auto sector. Many large banks have shrunk, because they are unable to compete on price.

Below are some of the key highlights from each segment.

Credit Cards

The data from Experian tracks credit cards issued by banks, and shows the dramatic and rapid growth experience during the second quarter.

  • $83 billion of new bankcard credit lines were issued, a post-crisis high.
  • 87% of the new credit lines were granted to prime and super-prime customers. But the accelerated growth is coming from near-prime.
  • There was a 7% growth in credit limits issued to customers with near-prime scores. A total of $8.2 billion was issued during the quarter.
  • Credit card balance growth is starting to accelerate. Balance growth always lags limit growth, but there was a 3% growth rate in balance during the quarter and looks set to accelerate.
  • Credit card losses remain around 4%, and delinquencies remain at low levels.

Auto Loans

Auto loan growth continues at a rapid pace, and a lot of the lending is happening with lower risk borrowers from nonbank lenders and credit unions.

  • $160 billion of new loans were granted in the quarter, a 16% increase over the prior quarter.
  • $577 billion of loans have been issued in the last 12 months, up 10% compared to the previous rolling 12 months.
  • Subprime auto loans expanded 14.8%.
  • Near-prime volume is also up 15.3%.
  • 56% of all auto loan originations are from non-prime consumers.
  • Credit unions are now responsible for 25% of all originations, and finance companies are responsible for 18%. Traditional banks are losing market share to finance companies and credit unions.
  • At credit unions, 34% of originations are to borrowers with credit scores that make them either near-prime or sub-prime. This raises concerns about the amount of risk that credit unions are taking in a high risk segment of the market.
  • Auto loans have crossed the $1 trillion balance mark, an increase of more than 10% compared to last year. Since 2012, auto loans have increased a staggering 43%.

Mortgage Loans

Since Q1 2014, mortgage volume has started to accelerate rapidly. Fear of an interest rate increase has inspired a lot of refinance activity now, while rates are low. And the purchase market continues to heat up, as more people decide to purchase homes.

  • Mortgage originations have increased 50% since the trough of Q1 2014.
  • Nearly $1 trillion of new mortgages have been originated so far this year.
  • Purchase mortgages are now at 57% of total mortgage volume.
  • California, Texas and Florida continue to dominate the market.
  • The fastest growth in coming from Hawaii, South Dakota and Washington.

In addition to first mortgages, the Home Equity Line of Credit (HELOC) business is accelerating. $42 billion of HELOC were originated during the quarter, an increase of 23.5%. Equity withdrawal continues to remain most popular in states like California and Florida.

Implications

Anyone who has been in banking for a long time understands that credit is cyclical. Right now, we are clearly in an expansionary phase of the credit cycle. Borrowers who were once toxic look good again. Top line growth is accelerating. Coincidental delinquency and losses look good. And we all convince ourselves that we have learned out lessons from the past cycle.

One thing is clear: at some point delinquency and losses will increase. The quality of the underwriting today will determine the extent of the deterioration in the future. Credit card businesses should be least at risk, because of their high interest rates and ability to mange the credit limits. Subprime auto loans underwritten by credit unions, with limited experience and low interest rates, pose a much greater risk. But only time, and more data, will reveal the wisdom of decisions made by both banks and borrowers.

Nick Clements
Nick Clements |

Nick Clements is a writer at MagnifyMoney. You can email Nick at nick@magnifymoney.com

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Crisis Looming: 53% of Resetting HELOC’s are Upside Down

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Home Equity Lines of Credit (HELOCs) were very popular before the 2008 crisis. If you had equity in your home, you could open a very low cost line of credit, making it easy to borrow against your home. The typical HELOC would have a 10 year drawdown period. During that time, you could use your line of credit by writing checks, transferring funds electronically or even using a special purpose debit card. Yes, you could finance a flat-screen television using your home as collateral.

During the 10-year drawdown period, you would typically only need to make interest-only payments on the amount that you had borrowed. And the interest rates were incredibly competitive. Some bans were even offering interest rates below prime during the drawdown period. For example, if you had a $30,000 balance, your monthly payment could be a low as $50. Even better, that $50 was tax deductible, which meant you would be getting a refund at the end of the year. It became incredibly easy for people to run up significant debt. And, with real estate prices increasing rapidly, borrowers continued to feel wealthy, because the value of their home continued to outrun the balance of their debt.

At the end of the 10 year drawdown period, the payments would convert to a 20 year amortizing loan, at a much higher interest rate. Depending upon your credit score, the interest rate could go from 2% to 9%, for example. In the $30,000 example above, the payment would increase from $50 to $270. That is a dramatic price increase, otherwise referred to as a payment shock.

When these loans were originally sold, brokers and bankers told borrowers not to worry about the rest. The general belief was that house prices would continue to increase, and banks would continue to lend. You could always refinance the balance and go back into another interest-only drawdown period. The promise to borrowers was that you would never have to pay off your debt, and many people believed that promise.

Fast forward 10 years, and many of the HELOCs issued during the crisis are now resetting. But there is a problem: it is almost impossible for subprime borrowers to find a bank willing to lend. And, even worse, 53% of the resetting HELOCs are on properties that are upside down. In other words, the balance of the mortgages is greater than the value of the property, which means no bank will lend, even if the credit score is high.

That creates a big issue for borrowers who can not afford the rate reset. If they can’t afford the new monthly payment, and can not find a new lender willing to underwrite the risk, they will risk foreclosure.

RealtyTrak yesterday released a report detailing the scale of the rests coming. And the story does not look good. 3.3 million HELOCs are scheduled to reset over the next 3 years. The average payment shock will be $140 a month, but a significant number of people will see much bigger resets.

But the real issue is that 53% of the HELOC customers (1.8 million people) are upside down on their property. That means their home is worth less than the balance of their mortgages. For these individuals, they will be at high risk of foreclosure.

The next 3 years will be challenging for borrowers, and we will be watching closely to see what loss mitigation options banks propose. But even principal forgiveness is not without it challenges, as the borrowers may have a tax liability as a result.

 

Brian Karimzad
Brian Karimzad |

Brian Karimzad is a writer at MagnifyMoney. You can email Brian at brian@magnifymoney.com

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