Understanding Your Debt Options

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Dan Steadman

Financial Advisor, DCL

Understanding Your Debt Options

Since financing institutions started to relax lending policies, Americans became more likely to borrow money than ever. This has resulted to troubling trend. By the end of this year, household debt is expected to total to $12.73 trillion which is around $50 billion higher than 2016.

The consumers’ misplaced optimism is perhaps the biggest reason why they spend more on luxuries such as cars and even second homes. Unfortunately, the cost of living is growing at a faster rate than income. Although they can afford that new car and house now, they may find it too expensive when the basic needs start to take too large a piece of the pie.

As supported by statistics, mortgages still are the biggest percentage of the total household debt. However, other loans such as credit card loans and auto loans are significant as well.

 

Why Are Americans Carrying So Much Debt?

The cost of living and stagnant wages are the biggest reasons why many Americans fall into debt. Even with smart budgeting, it can be impossible for some people, especially those with their own families, to make ends meet and to set aside some money in case of emergencies.

These conditions make them totally defenseless when an unexpected expense comes, leaving them no choice but to use credit cards. Having established that they are living paycheck to paycheck, they usually fail to pay their creditors and the debt accumulates over time.

There are also people who can afford to live without credit, but unfortunately are lacking in managing their finances. Thus, they get a credit card, thinking they are too poor to live without it. Month after month, they may be unsuccessful in paying the full amount so the interest accumulates. After some time, depending on actual spending, they have tens of thousands deep in debt and cannot borrow anymore.

Needs vs Wants

There is the idea that people will be more responsible in spending if they would only be able to differentiate what they truly need vs. what they want. It’s easier said than done, though. For example, coffee may be considered as a need by many people; and that’s perfectly reasonable. However, it doesn’t always have to be a Venti Starbucks with extra soy or vanilla syrup. The latter is a preference – and an expensive one at that. This cup of coffee that you want could set you as far back as $5; while a regular cup of brewed coffee can go for a $1 or even free when you have breakfast at a diner.

A car is a need because it can get you to destinations you need to be, but if it’s beyond your means, you don’t have to take out one loan after another to buy a luxury brand or a sports car. A lot of Americans make this mistake thinking they can just take a second job or depend on the raise they’re expecting. When things fall through, this is when they get into big trouble because they’re in way over their heads with debt.

Assessing needs vs wants doesn’t mean depriving yourself of what is beautiful and enjoyable for you. Rather, it aims to make you aware of what you can afford at your current income level. How much do you have to spare each month for mortgage or rent? Make realistic calculations and see how much you can afford before taking out a car, a new apartment, or splurging on designer shoes and bags. You can shop and buy what you like when the actual money arrives. This will prevent you from spending more than what you actually have and keep you from charging everything to your credit card and then paying interest and other charges later on.

Some people take a different approach and reserve buying and spending after they have saved the actual amount needed. This concept of delayed gratification keeps people from taking instalment loans and cash advances because they set aside the money first instead of borrowing money to purchase a certain item. The savings is built slowly through months or years of setting aside small amounts of cash – from salaries, bonuses, or income from small side projects. Once there is enough money, the person proceeds to buying the designer bag she wants or goes on that tropical island vacation that the family has been planning for,.

This is the ideal scenario, but the truth is very few people have the ability and patience to wait before they buy the things they want – no matter how frivolous they may seem.

Is there a solution?

Ideally, people would realize the problem and deal with it early on and realize where they are wrong. Unfortunately, this still means that they have debt they cannot pay off.

If avoiding bad spending habits is not enough, the best course is to create a payoff plan that given your situation, is realistic. One of the most popular options is a debt consolidation loan as it fits most people’s budget.

Pros and Cons of Debt Consolidation Loans

Pros

There are a number of reasons that consumers find debt consolidation loans to be viable:

  1. Simplicity

Paying only one creditor instead of many gives the illusion of control to people. Simplicity means less hassle in budgeting monthly expenses, including deb payments.

  1. An opportunity to start anew

Continuously falling behind on your payments dent your credit score. To repair this, they resort to debt consolidation loans.

  1. Lower interest rate

People might feel they are “tricking the system” through this option because of lower interest rates compared to credit cards. Everything going well, it is possible for one to save a considerable amount.

Cons

Sometimes, augmenting your income and cutting back on spending are not enough to cover your expenses, thus this solution. Even with all those pros, debt consolidation loans also have is fair share of downsides. Make sure to note these before talking to your creditor:

  1. Possible budget mismanagement

Having no credit card debt to pay anymore, some people get the illusion that they are free of debt when in fact, it has only been transferred. This can result to spending a little more every day, and these increments can be significant when summed up at the end of the month.

  1. Higher payments in interest

As a result of budget mismanagement, you may be too broke to address your loan. While debt consolidation loans have lower interest rates, the lapses in payment will accumulate while the interests are compounding every month. In the end, you may end up paying more in interests than in your credit card.

Making a commitment to change your spending habits is necessary before going for a debt consolidation loan. If you do not have discipline, this may not be your best option.

 

The Different Types of Debt Consolidation Loans

Debt consolidation is the process of paying your debts through a loan. This releases you of the responsibilities from your original debtor by “buying” you time through more manageable payment plans. The nature of debt consolidation can either be secured or unsecured depending on what type you choose. What might be the best course for you depends on the following factors:

  1. The amount you need
  2. Whether you have a mortgage or not
  3. Your credit score
  4. Whether you need a short-term or long-term loan
  5. Your interest rate tolerance
  6. Whether you have a valuable asset to secure the loan

Once you are sure that a debt consolidation loan is your best option, deciding what exactly the type of it you are going to avail of. Here, we will discuss the different types in consideration of the six factors listed above.

 

Refinance of Your Current Mortgage

For people who currently has a mortgage, the most popular action taken when hard times hit is refinancing. Basically, what happens here is the total amount you owe in your current mortgage becomes even larger, and the added amount is used to pay off other debts.

How much more in interest you will have to pay depends on market conditions. Good market conditions mean lower interest rates, and with good money planning, will translate to easier budgeting. Even if the situation is on your side, one should note that like all debts, it is not without consequences.

One of these is the closing costs which is what you pay the bank to allow you to refinance your mortgage. This can easily amount to a few thousand dollars that you pay upfront or add to your loan balance. You never see nor use this money, but it is still a very significant charge you will incur. Like your mortgage, it also accumulates interest over time.

Mortgage in itself already puts your home at risk of foreclosure. While helping you in the short run, what refinancing does is make it harder for you to avoid that possibility. For the life of the loan, it means bigger bills to pay at the end of each month.

In order to survive the consequences of refinancing, you will have to make changes in how you live. Maxing out your credit card, for example, is something you should avoid. Else, you may be left without home and money.

 

Home Equity Line of Credit (HELOC)

Homes appreciate in value all the time, making HELOC a good proposition. Here, you will obtain a mortgage that will allow you to a certain amount of money depending on the value of your home. It is not given in cash, but the borrower can access it anytime for any purpose it may be needed.

This is generally very relaxed as this credit can be paid in any amount, but there is an interest accumulated every month. Most of the time, true value of your home is less than its worth in mortgage due to inflation and perhaps positive real estate market condition.

While this may be a convenient solution in alleviating dismal financial health, it you’re your house, one of your most viable assets, at risk. HELOC, in essence, transforms your unsecured debt – which will only hurt your credit rating and chances for loan approval – to secured debt.

If you hold that mortgage for a long period of time, it may prove that paying credit card debts on your own instead of taking out a mortgage to be the more logical option. The numerical amount of the interest on mortgage can be greater than in your other debts.

 

Personal Loans

There are numerous benefits that clients who normally manage to make their monthly payments or have good credit rating can obtain from their banks. One of these is personal loans.

Most of the time, banks will only offer a limited amount for this kind of loan so this is a good option if you do not deem your debt substantial. Aside from your signature, you do not need to meet other requirements nor put up any of your valuables as a collateral.

A personal loan can be used for anything. However, for our purposes, it is a great option for buying you a little time to attend to more significant debts such as mortgage. As such, the loan term is usually shorter while the interest rates are higher than that of a secured loan.

While that may be the case, the total nominal interest paid is still smaller for short-term loans such as personal loan compared to a long-term loan like mortgage.

 

Other Options

Often, consumers don’t address their debt problem until the situation becomes difficult to resolve. If they wait too long, they may fall behind on their payments, hindering their ability to obtain a debt consolidation loan. Either credit has suffered damage to the degree that creditors are not willing to extend more credit, or the consumer does not have an asset to borrow against.

Before considering bankruptcy, consumers should consider these options to relieve themselves of overwhelming debt. While these option will surely hurt your credit score, it is still not as severe as filing for bankruptcy.

Even on the first signs that you cannot handle the payments, understanding your debt options is critical. All your possible recourse, as listed above, will help you recover in times of financial crisis.

Dan Steadman

Dan Steadman

Financial Advisor, DCL

Dan is one of the top financial experts when it comes to debt consolidation. With more than 20 years of experience helping people tackle debt, he has a unique insight when it comes to solving debt-related problems. 

Dan got his start when he went to work for a bank after getting his Business Degree. He worked his way up and became a loan officer. This position gave him unique insights into the ways that financial products work and how people can utilize different financial products to improve their lives. He’s seen hundreds of success stories and just as many failures – so he knows what steps are most likely to help his readers.

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