By Douglas Hoyes, Founder & Trustee of Hoyes, Michalos & Associates
When you find yourself facing a great amount of debt, you may begin exploring ways to dig yourself out. For many people, debt consolidation using home equity seems like a no-brainer. Why juggle multiple monthly payments when you can have just one? And why continue paying high interest rates when you have the option of paying a much lower one?
While debt consolidation can in fact be a smart choice for anyone dealing with excessive debt, there are a number of factors to consider before taking the leap. The approach that worked well for a friend or acquaintance may not be such a good fit for your unique financial situation. By taking an objective look at your spending habits, you'll be able to choose the option that's best for you.
Do you really need help?
Before exploring your debt relief options, you should first realistically assess your financial situation to determine whether or not you indeed need help. There is a chance that, with careful budgeting and cutting back on your spending, you could be debt-free within a few months. However, there are some clear warning signs that you need to seek outside help:
- Your credit cards are a necessity -- not a convenience
- You're constantly borrowing more money and struggling to pay it back
- You're only making the minimum payments on your debt
- You're getting regular calls -- and threats -- from creditors
- Your wages have been garnished to pay your debts
- You regularly go over your spending limit on your account and use overdraft protection
- You have no idea how much debt you really have
- Arguments about money are causing problems with your loved ones
What is Debt Consolidation?
A debt consolidation loan is a loan from a financial institution that allows you to group together multiple debts into one monthly payment. For example, you may owe $20,000 on three different credit cards, and the consolidation loan would allow you to pay off all three of those cards. Then, your only responsibility would be toward the consolidation loan -- it's the same amount, but only one payment.A popular type of debt consolidation loan is tied to the debtor's home mortgage. You may be able to consolidate various debts into your mortgage either by refinancing or by taking out a second mortgage. A loan that is secured by the equity in your home will often have a lower interest rate than other debts -- and there's a reason for that.
Understanding secured vs. unsecured debt.
To understand why you can receive a better interest rate on a mortgage debt consolidation loan versus other loans, you need to recognize the difference between secured and unsecured debt. Secured debt is attached to an asset such as a house or car, so that if the owner defaults on their payment, the bank may seize the property to repay the loan. There's less risk involved for the financial institution, which allows them to offer a lower interest rate in many cases.
Unsecured debt, on the other hand, is not attached to an asset. Credit cards are an example of this type of debt.
While a lower interest rate is clearly preferable and can take a lot of pressure off of you, there is a very real danger to making this choice. By converting your unsecured debt into secured debt, you risk losing your house or car if you're unable to make your payments. If you're not positive that you can make your payments, this is not a decision you should make.
Should you take out a second mortgage?
Before you dip into your home equity, ask yourself these three questions:
- Do you have enough equity in your home?
- Can you definitely afford the monthly payments?
- Are you sure you won't risk foreclosure?
If you answered "no" to any of these questions, you should consider alternative forms of debt relief.
Do you notice I didn't ask if you qualified for a second mortgage? Make the decision based on what's best for your finances, not whether or not the bank is willing to loan you more money.
Consider a consumer proposal.
Debt consolidation isn't the only way to deal with excessive debt. You may want to consider an alternative option: a consumer proposal.
In Canada, a consumer proposal allows you to combine several unsecured debts into one monthly payment without risking losing your home. This is because you make a proposal to pay the equity in your home to creditors over a period of time. Because it's not a new loan, the interest actually stops altogether. It also allows you to settle your debts for less than the full amount. This is a great option if the total amount of your unsecured debts is more than the equity value of your home.
If you're still not sure which option is best for you, try using this debt relief calculator to compare options. And if you need a second opinion, consider contacting a debt management expert, like a bankruptcy trustee, to discuss debt relief options.