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Debt consolidation can be achieved by taking on a larger debt that pays off various other small loans. Achieving this with an unsecured loan is impossible in the current economic environment and even if available the servicing cost is high and decreases the benefits of consolidation. Secured loans offer an easier way out of financial distress in the short term. Home equity loans are a form of a secured loan.
These are second position liens against the existing equity in a home. They reduce the actual equity in the house by increasing the amount of debt secured against it. When considering the option of debt consolidation using HELs, it is important to keep a number of factors in mind.
Advantages of Home Equity Loans
Home equity loans have the advantage that they can be used to consolidate credit card debt and reduce the monthly expense from finance charges. The loan is usually of a shorter duration than a normal mortgage but has a lower interest payment as well. Credit card debt is usually unsecured debt, which is why the cost of servicing is so high. Consolidation of debt in this manner effectively converts unsecured debt into secured debt. The interest payment is also tax deductible on income tax returns, making this form of consolidation even more effective.
Disadvantages of Home Equity Loans
Despite the fact that these loans offer collateralized lump sums to consolidate debt, there are significant shortfalls in this method. The foremost disadvantage is that they require the presence of an asset under your name and a good credit history. It has been observed practically that most people in financial distress do not have either of the two.
Before a loan can be granted, there are a number of fees that have to be paid, which includes legal fees, valuation fees, and originator fees. These can add up to make the cost savings from HELs very small.
Traditional mortgages are usually non-recourse loans, where the lender will have the right to the asset on bankruptcy but the borrower will not be held responsible beyond that. However, since HELs are second lien loans, these are recourse loans, for example the borrower can be held responsible personally in case the home equity is not sufficient to cover the debt expenses.
Another problem with this form of debt consolidation is that it is risking a valuable asset for the disposal of unsecured debt, thereby increasing the risk of the borrower in the event of a foreclosure. This risk coupled with a clean slate of credit card bills can lead to a great financial disaster unless appropriate care is taken. Many analysts blame the current mortgage crisis on similar refinancing done in earlier years when interest rates were low.
Whether or not to go for a home equity loan will depend on the specific circumstances of the consumer. If there is still considerable equity in the home and it can accommodate a reduction; if the consumer has or will have the ability to pay the mortgage payments and most important of all if the consumer is really serious about the reduction of overall debt and is not just utilizing the equity loan to extend their shopping spree. Apart from home equity loans there are many other options available for debt consolidation. It is possible to refinance any mortgage asset; in particular refinancing your car can be an attractive option.
In either case it is important to remember that debt consolidation through HELs will not remove the burden of debt, in fact it might even increase the absolute burden. The only major benefit is that it allows the repayment of debt in a more manageable fashion. The problem with debt consolidation is that unless there is an ability to repay the debt in the future, it can be a very slippery slope leaving the distressed consumer homeless and without any other option.
Home equity loans offer significant benefits in the consolidation of debt, but only to the relatively well off, i.e. those who own homes and have good credit. People who do not meet the criteria should focus on other means of consolidation rather than risking their residences.