All financial planning distills to one main concept driving one goal: the most efficient and profitable use of capital. Corporate CFOs focus on this goal. Corporations ensure efficient and profitable use of capital by paying the lowest interest possible on their debt. Consumers should behave the same way.
Sounds simple, right? Good, now let’s use this rule! You already know that credit cards and other unsecured debt cost you a high rate of interest. The concept is a simple one that you already know from investing: returns correlate to risks. The higher the risk, the more an investment will pay you as compensation for that risk. Your creditors view the money they loan you as an investment. The higher risk that you or the loan, or both you and the loan, present them, the more interest they will charge.
Generally, your creditors use your credit score to evaluate your risk profile. As you already know, you can behave as well as possible by paying on time etc and still have a low credit score due to a high amount of total debt.
Credit Card Debt
Similarly, your creditors use the security of a loan to determine its risk profile. Credit card debt costs high interest because it is unsecured; meaning that if you refuse to pay or if you file bankruptcy, the creditor holds no lien against a specific asset that it can encumber (repossess). Conversely, mortgages cost low interest because the creditor can repossess the asset in the event of a payment failure.
So, in order to most efficiently use your capital by paying the lowest interest possible, you should lower your total debt amount and/or lower the risk on your borrowings. While debt consolidation poses its own problems and can sometimes lead to other financial problems, it does offer many debtors a way to lower their risk (and thus their interest) and sometimes even their principal.
As the name indicates, debt consolidation allows a borrower to group or consolidate several smaller, usually unsecured high interest loans, such as credit cards, into one larger loan. While a debtor can sometimes use a large unsecured loan to consolidate smaller ones, this often makes no financial sense. As noted above, the use of a larger secured loan, such as a mortgage refinance or a home equity line, decreases risk through collateralization, and thus leads to lower interest rates, which means that borrowers can pay down more principal with each monthly payment, and thus reduce their total debt amount quicker.
While saving money on interest is always a good idea, certain emergency situations warrant immediate action to consolidate. These situations arise when borrowers have maximized their credit card debt and find hardship from high interest and principal payments. Even more troubling, such hardships can force missed payments, which trigger late-fees, penalties and higher interest, further deepening a borrower’s already unmanageable debt situation. The ensuing downward spiral often leads to bankruptcy. Four key debt consolidation methods exist.
Collateralization of Assets
Borrowers who own assets that can be collateralized, such as ownership in a business or an art collection can often borrow against the value of those assets. That said, most individuals who own valuable businesses or art collections don’t need to consolidate debt. More commonly, borrowers use their homes as the secured asset.
Property prices rise over time. Conversely, homeowners pay off more of their mortgages every month. Due to both of these facts, a borrower’s home may possess unlocked equity. A homeowner may choose to refinance his or her mortgage and either lump the unsecured debt into the new mortgage or use the excess cash gained from paying off the old mortgage with the new higher one to pay off the unsecured debt.
In order for this solution to make financial sense, a homeowner must be certain that his or her income will prove sufficient to pay the new higher mortgage. A homeowner must also ensure that the fees on the new loan do not exceed the interest costs of the unsecured debt. Of course, no one should ever pay old debt with new higher interest debt (in finance, that’s known as a negative arbitrage and should be avoided at all cost).
Home Equity Loan (HELOC or Second Mortgage)
Rather than refinancing the entire mortgage for the whole value of a house, a homeowner may choose to borrow only against the unlocked equity of his or her home. Such a loan is often called a second mortgage since it stands second in line for repayment from repossession in case of a default. Given the discussion of risk and return above, that should indicate immediately to you that a second Mortgage will cost higher interest than refinancing a first mortgage. The higher interest, when added to the higher fees that second Mortgages also charge, can obliterate interest savings from the refinancing of unsecured debt. Furthermore, if house prices plummet, homeowners may find that they owe more than the total value of their homes.
However, if a homeowner bought his or her home at a time of lower interest rates, it would prove more economical to borrow a second mortgage than to refinance the first. After all, it makes no sense to pay a higher rate of interest on your first mortgage in order to consolidate unsecured debt. In fact, in such a situation, a borrower may worsen the situation.
Unsecured Consolidation Loans
Borrowers who do not own a home can find it difficult to consolidate using traditional methods. However, some financial institutions offer unsecured consolidation loans. Generally, these loans make little financial sense as they carry interest rates almost as high, or as high as the unsecured loans being consolidated. Then again, they consolidation loan may offer a longer term, and thus, lower payments, easing a borrower’s cash flow burden.
Similar to the process of debt settlement, and often using the same tactics, debt consolidation companies can sometimes discount the debt prior to consolidating it. When the debtor exhibits a danger of bankruptcy, the debt consolidator can buy the loan at a discount from the lender. The debt consolidator can then lend the borrower a consolidation loan for the new, smaller amount. A word of warning, do not attempt this method on your own, prior to seeking a mortgage refinance, home equity loan or unsecured consolidation loan as it will worsen your credit, making it impossible to borrow the loan with which you wish to consolidate your unsecured debt. Only try this method with a loan consolidator who has already agreed to finance the consolidation. Also make sure that the consolidator is willing to pass most of the savings of the discount to you.