Last week I stumbled on a rising trend where financial companies are encouraging you to get out from under your credit card debt by taking out a “debt consolidation” mortgage loan. Heck, one radio ad I heard made it sound seriously enticing: no closing costs, a great interest rate, you set the length of time you want to pay back the debt, yadda, yadda, yadda.
Like most ads, however, the copy highlights only the possible benefit. It doesn’t include the drawbacks. And glancing through a bunch of articles written previously on the topic, neither do most writers. So, What Would Paula Say about this topic?
First, housing prices have seen a meteoric rise in the past few years. This gives people enormous amounts of equity in their homes. I call this “phantom equity” because it’s artificial and only exists on paper. Unless you’re selling your home and using those sales proceeds to pay off your credit card or other debts, and then literally tucking the rest of your money away, this is NOT real money.
Finance companies, however, are gleefully working overtime to convince you to tap your equity and use it to pay off debts or finance a home improvement project before prices drop again and you lose your chance. The million dollar question is: are you sure you want to shoulder the extra monthly cost and have it attached to your home?
When you use your home equity to pay off unsecured debt, you put yourself at risk of losing your home. Because now you’ve increased your mortgage payment(s) and turned what was “unsecured” debt into debt secured by your home.
Anyone who knows me will agree that I’m not a doom and gloom person by any means. I am, however, a big picture person. So I like to look at all the pros and cons and make decisions based on whether or not I can live with the outcome of any “cons” on the list.
What are the “cons” about these “debt consolidation mortgage loans”?
- What happens if house prices in your area suddenly drop? Now you’ve got a house worth LESS than what you owe, but you’re still responsible for making the mortgage payments on time every month. Miss payments and foreclosure becomes a real possibility.
- What happens if your income is cut for any reason? Illness, a layoff or job loss can happen suddenly and can blow through any savings pretty quickly. And if the housing market has soured, then you can’t sell your house in order to even pay your daily expenses.
- You could wind up with a shorter mortgage term than what you currently have – the ads are quick to say things like “5 years, 10 years, 15 years – you get to determine how much time you get to pay off this loan.” Nowhere in there do they actually say, “hey, you’ve got 24 years left on your 30-year mortgage and you’ll have that same amount of time to pay off this debt!” Ultimately, they decide how long your repayment period will be.
- You may wind up paying more interest over time AND could end up increasing the overall interest rate of all your home debt if they convert your entire debt to a new mortgage loan.
- If you wind up in financial difficulties, where getting out from under your unsecured debts would have helped you, you would be out of luck. Consolidating your debt turns all your “unsecured debts” (like credit cards, medical bills, etc.) into “secured debt” connected to your house. So the legal option of bankruptcy may no longer be an available option for you.
Ask yourself this question: Why are finance companies so eager to help you convert your credit card debt to a “debt consolidation” loan? (Notice they call it “paying off” your credit card debt – but you’re actually just converting the debt to a new loan.) Because once you move your credit card debt to this new loan, all your credit cards suddenly have zero balances. Because psychologically we think of “credit cards” as “extra money” in our lives, most people who move their credit card debt into a new loan actually keep their credit cards. And then they start using them again, and carrying balances on them again. Which means you now have MORE debt, rather than less debt!
Want TRUE financial freedom? Then start taking steps now to break the debt cycle – for good. Set up a plan to start building your net worth and slowly pay off your existing debt rather than moving the debt around, or running the risk of taking on new debt. More about this strategy next week!