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“Debt Consolidation”
Do You Know the Facts?

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Home Equity Loans & Second Mortgages

Everything mentioned above regarding debt consolidation loans apply here as well. In fact, consolidation loans are often home equity loans. Consolidation loans, however, need not be a home equity loan.

A home equity loan and a second mortgage both use the equity in your home as collateral. A home equity loan typically provides a “line of credit” and only when funds are drawn from it do interest charges accrue and payments begins. In contrast, a second mortgage typically provides the borrower with a “lump sum” of money. Interest is charged on the entire amount borrowed and monthly payments begin immediately. Both types of loans typically require processing fees, an appraisal fee and possibly other costs.

The annual percentage rate (APR) of such loans may be extremely reasonable. Consumers, however, must factor in all of the costs of getting the loan. After doing all of the calculations, in some cases, the actual cost may be much higher than anticipated. Even so, the net result could end up with a better interest rate than your current average interest rate of the debts you intend to pay off—if that is what you intend do with the proceeds! On the other hand, depending on many factors, including your credit worthiness and equity, the cost of processing the loan and resulting monthly payments might not provide you with any relief at all.

The problem most debtors have—is not having enough equity in the first place. Traditionally, lenders use a formula for determining eligibility and how much they will lend. This is usually based on a percentage—from 50% to 80% of the current market value of the home, less the amount that is still owed on it. If the current market value is appraised at $100,000, lenders will typically lend $50,000 to $80,000 maximum—that is, if you own the home free and clear. If the amount owed is $75,000 and the home owner is able to find a lender offering a loan at an 80% loan-to-value ratio, he or she may get a $5,000.00 loan. After paying the processing fees and other costs, however, they would only get a portion of this amount.

The advantage of a second mortgage or a home equity loan is that the interest is tax deductible for individuals itemizing deductions. Therefore, one must take this aspect into consideration and analyze the net result after taking this deduction. It may prove beneficial to discuss this issue with an accountant.

Whether a home equity loan or second mortgage is right for you depend on many circumstances, but generally you need a fair amount of equity in your home to make it worthwhile. Also, as noted under “Debt Consolidation Loans” there are many risks and concerns that must be considered. In particular, should you default on the loan, you could end up losing your home. If the purpose for acquiring the loan is primarily to consolidate “unsecured” debt, you are well advised to give it serious thought.

A better option may be to just borrow enough to consolidate “secured ” debt, and perhaps certain unsecured accounts that are likely to result in legal action should the debtor default. This would lower the monthly payment and reduce the risk of defaulting on the loan. Should the borrower later run short, funds could then be taken from the budget allocated for unsecured debts. While this would place the unsecured account(s) in jeopardy, such action could, as they say, save the farm!

If a debtor has a significant amount of secured debt and unsecured debt, another option that may be available, is to obtain a home equity loan to consolidate “secured” debt and then enroll in a Debt Management Program (as described below) to consolidate “unsecured” debt. For heavy debtors this is a very viable option that provides a safety factor and could yield significant savings in interest charges, late fees and other charges.

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