Some homeowners opt to re-finance to consolidate their existing debts. With this type of option, the homeowner can consolidate higher interest debts such as credit card debts under a lower interest home loan. The interest rates associated with home loans are traditionally lower than the rates associated with credit cards by a considerable amount. Deciding whether or not to re-finance for the purpose of debt consolidation can be a rather tricky issue. There are a number of complex factors which enter into the equation including the amount of existing debt, the difference in interest rates as well as the difference in loan terms, and the current financial situation of the homeowner.
This article will attempt to make this issue less complex by providing a function definition for debt consolidation and providing an answer to two key questions homeowners should ask themselves before re-financing. These questions include whether the homeowner will pay more in the long run by consolidating their debt and will the homeowner’s financial situation improve if they re-finance.
What is Debt Consolidation?
The term debt consolidation can be somewhat confusing because the term itself is somewhat deceptive. When a homeowner re-finances his home for the purpose of debt consolidation, he is not actually consolidating the debt in the true sense of the word. By definition to consolidate means to unite or to combine into one system. However, this is not what actually happens when debts are consolidated. The existing debts are actually repaid by the debt consolidation loan. Although the total amount of debt remains constant the individual debts are repaid by the new loan.
Prior to the debt consolidation, the homeowner may have been repaying a monthly debt to one or more credit card companies, an auto lender, a student loan lender, or any number of other lenders but now the homeowner is repaying one debt to the mortgage lender who provided the debt consolidation loan. This new loan will be subject to the applicable loan terms including interest rates and the repayment period. Any terms associated with the individual loans are no longer valid as each of these loans has been repaid in full.
Are You Paying More in the Long Run?
When considering debt consolidation it is important to determine whether lower monthly payments or an overall increase in savings is being sought. This is an important consideration because while debt consolidation can lead to lower monthly payments when a lower interest mortgage is obtained to repay higher interest debts there is not always an overall cost saving. This is because the interest rate alone does not determine the amount which will be paid in interest. The amount of debt and the loan term, or length of the loan, figure prominently into the equation as well.
As an example consider a debt with a relatively short loan term of five years and an interest-only slightly higher than the rate associated with the debt consolidation loan. In this case, if the term of the debt consolidation loan, is 30 years the repayment of the original loan would be stretched out over the course of 30 years at an interest rate that is only slightly lower than the original rate. In this case, it is clear the homeowner might end up paying more in the long run. However, the monthly payments will probably be drastically reduced. This type of decision forces the homeowner to decide whether overall savings or lower monthly payments is more important.
Does Re-Financing Improve Your Financial Situation?
Homeowners who are considering re-financing for the purpose of debt consolidation should carefully consider whether or not their financial situation will be improved by re-financing. This is important because some homeowners may opt to re-finance because it increases their monthly cash flow even if it does not result in overall cost savings. There are many mortgage calculators available on the Internet which can be used for purposes such as determining whether or not monthly cash flow will increase. Using these calculators and consulting with industry experts will help the homeowner to make a well-informed decision.