Close-Up: Debt Consolidation Loan

Physician's Money Digest, June15 2003, Volume 10, Issue 11

n.

Debt Consolidation Loan: A single, low-interest-rate loan that is used to pay off multiple debts.

There are an estimated 1.3 billion credit and paymentcards in circulation in the United States today.In 1999, Americans used those cards to make morethan $1.1 trillion worth of purchases. Combine thatwith data from the Federal Reserve that consumerhousehold debt is at a record high relative to disposableincome, and it's no wonder more than 1.5 millionnonbusiness bankruptcies were filed during 2002.

There are, however, alternatives to bankruptcy, andthat's where debt consolidation loans (DCLs) come intoplay. The objective of a DCL is to provide you with 1monthly payment that is lower than the sum of thepayments you are currently making on multiple debts.So instead of making monthly payments to yourMasterCard or Visa account, numerous departmentstore accounts, and travel card accounts at interestrates that can range from 10% to 18% or higher, youmake 1 sum payment at a more reasonable rate.

INTEREST RATE FACTOR

The key to making a DCL work is the interest rate:the lower the rate, the better. Consider that Americans,on average, carry $4800 in credit card debt from monthto month, with an average annual interest rate of 17%.If an individual were to make only the minimum paymenton that debt every month, it would take 39 yearsand 7 months to pay off. In other words, the individualwould pay $10,818.63 in interest alone, or a total of$15,619, for the privilege of having charged the original$4800. However, most people are able to get out ofdebt after only 3 to 5 years once the interest rates ontheir debts have been reduced under a DCL.

Beyond the reduced interest payments, taking on aDCL also has considerable advantages over filing forbankruptcy. The objective of bankruptcy is to absolvean individual of all debts. However, this pardon comesat a price. Applying for life insurance, purchasing abusiness, buying a home, orapplying for a job can all be negativelyaffected by a prior bankruptcy.However, with a DCL,you're making a commitment torepay your debt obligations. Youcan repair a poor credit rating,maintain a good one, and soon return to a debt-freelifestyle without negative consequences.

Keep in mind, though, that not all types of debtscan be consolidated under a DCL. Most unsecureddebts, such as credit cards, unsecured personal loans,medical bills, student loans, taxes, charged-off accounts,and debts owed to collection agencies, can beconsolidated under a DCL. Secured loans, such as mortgagesor car loans, cannot be consolidated.

PERSONAL LOAN OPTION

The Die Broke Complete

Book of Money

Since the interest rate is the key factor in a DCL, takingout a personal loan to achieve your consolidationgoal might not be the best way to go. According toStephen M. Pollan, author of (Harper Business; 2001), chances arethe interest rate attached to a personal loan will beclose to or even higher than what you're currently payingon your credit card debts. The lender may structurethe loan so that the repaymentterm is longer, thusreducing the amount of thesingle monthly payment andtemporarily easing some ofyour burden. Over thelong haul, however, youwill pay much more ininterest than if you hadcontinued paying eachdebt individually.

BETTER CONSOLIDATING OPTIONS

A home equity loan, which uses your residence ascollateral, is a much more sensible way to go, especiallywith interest rates at all-time lows. Pollan pointsout that most lenders will allow you to borrow up to70% of the equity in your home. For example, if yourhome is worth $150,000 and you have $80,000remaining on your mortgage, you have $70,000 worthof equity in the home and can borrow as much as$49,000. In addition, the home equity loan's interest isusually tax-deductible.

One additional consideration is to borrow from a401(k) account. Many plans will allow you to borrowup to 50% of the amount you have contributed at aninterest rate that generally runs about 2% aboveprime. You usually have 5 years to pay back the loan,and because you're borrowing the money from yourself,the interest you pay goes back into your account.However, there is a downside to borrowing from your401(k): by removing the money, you're reducing itspretax earning potential. Therefore, borrowing froma 401(k) account is a decision that requires carefulconsideration, especially if you are getting close toretirement.

Did You Know?

•On average, the typical credit card purchase isapproximately 112% higher than if the item waspurchased using cash.

•About 1 out of every 100 households in theUnited States will file for bankruptcy.

•In 1995, 92% of US families'disposableincome was spent paying down debts. This is upfrom 65% 20 years earlier.

•The average American household has 13 paymentcards, including credit, debit, and store cards.

•According to the US Department of Health &Human Services, 96% of all Americans will retire atleast somewhat financially dependent on the government,family, or charity.

•An $8000 debt at a rate of 18% interest, basedon minimum payments, will take you more than 25years to repay and cost more than $24,000 in total.

CME Quiz

1) Debt consolidation loans enable you to make:

  1. 1 monthly payment
  2. 2 monthly payments
  3. Interest-only payments
  4. Your choice of payments

2) The key factor in a debt consolidation loan is:

  1. The number of payments
  2. The frequency of payments
  3. The interest rate
  4. The lender

3) The type of debt that cannot be brought under adebt consolidation loan is:

  1. A delinquent bill
  2. A medical bill
  3. A student loan
  4. A car loan

4) A debt consolidation loan that uses your residenceas collateral is called:

  1. A personal loan
  2. A bridge loan
  3. A home equity loan
  4. A big gamble

5) When you borrow from your 401(k) account, you canpay it back whenever you like.

  1. True
  2. False

Answers: 1) a; 2) c; 3) d; 4) c; 5) b.