How to use debt consolidation to cope with high-interest debt
Today, Michael Fischer covers two closely-related subjects: high-interest credit card rates and debt consolidation.
High credit card interest rates (3:48)
“With the effects of compounding, having credit card debt is a really bad idea.” Credit card interest rates are high because lenders are taking a greater risk. When you buy a house, the bank knows there's something it can repossess if you fail to pay. But when you buy food or clothing on credit, there's nothing for the bank to take if the debt goes bad. Unsecured debt like this carries higher interest rates in order to compensate for the increased risk. “When we have credit card debt to buy things that drop quickly in value, we have the worst scenario on both sides.”
Debt consolidation (3:28)
Borrowing money against an asset, such as your home, allows you to obtain a loan at a lower interest rate than borrowing money via a credit card. Lenders feel such loans are safer, and are willing to charge less for them. This can be used to your advantage if you transfer the high-interest debt to a lower-interest debt. You can take several smaller high-interest debts and pool them together into a single low-interest debt. Because of the effects of compounding, this can save a tremendous amount of money.
This is exactly what I did after I cut up my credit cards. I had about $25,000 in debt scattered among various high-interest sources. I pooled all this money into a single home-equity loan. This has allowed me to save thousands of dollars on interest payments.
It's important to note that for this to be a viable solution, you must refrain from accumulating new debt. If you consolidate your debts, but then go out and acquire new high-interest debt, you've only hurt yourself. When you default on credit card debt, you don't really lose anything besides your credit score. But when you default on a home-equity loan, you lose your house.
Debt consolidation is a powerful tool, but it must be used responsibly.