"Debt Consolidation Loans" and "Debt Consolidation Companies", what exactly is the difference?

With the proliferation of debt consolidation companies recently, there is a lot of confusion about what exactly the difference is between them and debt consolidation loans.

A "debt consolidation loan" take place when a lender, individual or corporate, loans you money to pay off other loans and you sign a "note" promising to pay it back. Thus the term "loan". This can be a note loan, no security, a loan secured by personal property, a loan secured by a car, or a loan secured with your home, as in a mortgage loan. If you fail to repay this debt consolidation "loan", you will suffer the consequences. These can include collection calls and letters, being sued in court, having your wages or bank accounts garnished or losing your security (i.e. your car or home). However, unless you owe a large amount, most creditors are not willing to go to such extremes.

A "debt consolidation company" (also known as credit counselors) combine all of your unsecured monthly bills into one lower monthly payment and a lowered interest rate. Although the service is not a loan they may be able to assist you in dramatically reducing your overall interest rate and monthly payments. This is done through a non-profit credit counseling agency that is designed to assist you in the repayment of your unsecured debt. Creditors receive certain tax savings for contributing to the program, in return they offer reduced interest amounts sometimes as low as 0%. But only through an approved non-profit credit counseling agency can you obtain the best rates.

So if you have the available equity, it may make more sense to obtain a debt consolidation loan, or possibly even refinance your first mortgage along with other debt into a low rate, tax deductible loan. The reason of "may" is because if you are getting this loan to pay off debt, the absolute worst thing that you could do is to go out right after paying everything off and charge it all back up again.

Most of the time, not all but most, if you have a lot of debt and own a home, it's a good idea to consolidate those debts into one simple lower rate, lower payment and usually, tax deductible loan. If you do tend to spend whatever money is available, please do be careful not to run your credit cards back up. But also, you may want to make sure that you DO NOT get a home equity line of credit. This is like a credit card with a very large line of credit secured by your home. Think about it. If you're getting this loan for a debt consolidation, does it make sense to allow yourself to be tempted with an additional $10,000, $20,000 or more that's available as easy as writing a check?

Again, there are two sides to every story. So, if you feel that you can trust yourself, Home equity lines of credit can be very beneficial, even when you are using part of the line as a debt consolidation loan. For instance, if you are making an addition to your home, it can be very powerful to just write a check for it. Also, if your triplets are getting ready to enter that private college that they have worked so hard to get into, you may need a ready source of cash available.

As far as equity lines of credit go, just like everything else, it can be good or bad. One other note to be aware of, most home equity lines of credit have an adjustable rate.

The other type of debt consolidation loan is what's called a closed end 2nd mortgage. This is a loan with a fixed interest rate for a fixed amount with fixed payments and a fixed repayment schedule. If you have any difficulty controlling your spending, this is the type of debt consolidation loan that you will want.

The other option that is available is to get a debt consolidation loan by refinancing your first mortgage and getting "cash out" to pay off debt. This is a good idea if your current first mortgage rate is above the going rate. Say you have a 7% first mortgage and $20,000 in debt you'd like to consolidate. If rates are currently at 5.75%, this may be a very attractive alternative. However, make sure that you don't borrow more than 80% of the value of your home. If you do, you will be required to pay private mortgage insurance(PMI). This is insurance that protects the lender from loss in case you default, but you are the one who pays for it.

In cases such as this, with PMI, it may make more sense to get two loans. A new first mortgage at the lower rate with as much cash out as possible without having to pay PMI. And then a second mortgage to pay the remainder of your debts off. Even with the higher interest rate on the second mortgage, it may still be a better alternative than paying PMI. Have the loan officer or mortgage broker crunch the numbers and compare the two different scenarios to see which is best for your situation. But don't forget to include the difference in closing costs as well. Since there are two loans involved, there will be two sets of closing costs as well. However, make sure the closing costs on the second are MUCH LESS than the first.

Closing Comment

Stop paying those "high interest" monthly bills and take the stress out of your life! Use the power of your home to consolidate all your current debt into one simple low monthly payment. This option can save you a lot and can have huge tax benefits.