Tuesday, February 26, 2008

Debt Problems and the Dangers of Consolidation Loans

When people get into trouble with their debts, they usually have several different debts including credit cards, car loans, line of credit, and possibly student loans. The debts usually have different interest rates and different required monthly payments. Some debts are scheduled to be paid off quickly and others over a long period of time.

The idea of a consolidation loan is to borrow one large amount to pay off all of the other debts. For this to make sense, this loan would have to be at a low interest rate and amortised over many years to make the payments low enough for the debtor to handle.

To qualify for this type of loan at a low interest rate, the debtor might have to put up some collateral, and this collateral is usually a house. The consolidation loan then turns into a home equity line of credit (HELOC).

On the surface, this seems like a good strategy. A lower interest rate means that you pay less interest. What other considerations could there be? I can’t say that I ever thought about this much, but a HELOC seemed to make sense if you are in debt trouble.

I was reading Suze Orman’s latest book “Women & Money” and she is dead set against this strategy saying “never use home equity to get rid of credit card debt.” Her reasoning is that if you got into trouble once, then you are likely to run up your credit cards again. Then you will have credit card debt and the HELOC to pay off. And if you can’t pay them off you will lose your house.

My first thought was that I disagreed with Orman. A rational person would consolidate the loans and then bring spending under control. But a rational person probably wouldn’t have had debt problems in the first place.

It is possible for someone who manages his money well to have some big expensive event occur that throws him into more debt than he can handle. But this is infrequent compared to the number of people who make poor choices that result in having debts spinning out of control.

So, I think Orman is right. Most people with debt problems probably should not consolidate their debts into a HELOC.

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