Every year millions of Americans enter into a variety of debt consolidations. As the popularity of debt consolidation has increased, so has the number of dangerous pitfalls in these debt consolidation programs:
Pitfalls of Home Equity Loans
Pitfalls of Balance Transfers
Pitfalls of Debt Consolidation Loans
Pitfalls of Debt Consolidation Programs
Home Equity Loans
The major pitfall of all second mortgages, home equity loans, and home-improvement loans is that the creditor requires borrowers to pledge their home as collateral for the loan. The creditor acquires a lien on the property, and if the borrowers can't afford to make their monthly loan payments, the creditor can take the home through foreclosure, even if the borrowers are current with their first mortgage payments.
Home equity loans are often used as a "quick fix" for people who simply don't have sufficient income to repay their unsecured debts, but they can result in long-term payments that are beyond their means. All of the states have laws that protect a certain amount of home equity from creditors. These laws allow people to discharge their unsecured debts through a Chapter 7 Bankruptcy, and keep the protected equity in their homes. The equity is also protected from any creditors who have claims eliminated in the bankruptcy. When people pay off their credit cards or other unsecured debts with a home equity loan, they turn dischargeable debt into secured debt that will survive a bankruptcy unless the home is surrendered to the creditor.
These loans are often attractive to consumers because they usually offer low interest rates and lower monthly payments, but the total amount of payments often adds up to be much greater than the original amount of debt. The total amount of interest over such a long period of time, usually 15-30 years, can be huge. With the frequently changing economy and unstable job market, home equity loans can quickly turn disastrous for many people. Creditors are willing to offer these lower rates because they know that they can foreclose on the property if the borrower is unable to pay back the loan. Furthermore, when interest rates are low, borrowers are especially susceptible to getting in trouble with home equity loans. Most home equity loans are variable rate loans, and the interest charged by the bank increases as the Federal Reserve Board increases the Prime Rate. As interest rates increase, a once affordable home equity loan payment may sky rocket, making the home equity loan payment unaffordable
Many home equity loans also have other costs that aren't always apparent, and can quickly add up to reduce the overall benefit of the loan. The borrower is usually responsible for paying for an appraisal, title insurance, and origination fees. Lenders can pack the deal with other extra charges like credit life insurance.
Other pitfalls of home equity loans include "teaser rates" and "balloon payments". A "teaser rate" is a low introductory interest rate that can increase during the term of the loan, sometimes by several percent, drastically increasing the total cost of the loan. A "balloon payment" requires the borrower to pay off the entire amount of the loan after a set period of years. That usually results in more borrowing and new fees. Borrowers with poor credit might not be able to acquire a big enough loan to pay the balloon payment, and can quickly find themselves in foreclosure. Some home equity loans can be "flipped" into a new loan with a higher interest rate and add other additional costs.
More and more people who get home equity loans find they end up owing more money on their houses than they are worth. This can be very risky, and although real estate prices traditionally appreciate over time, it is dangerous to count on the value of a home increasing to meet the total amount of debt secured by the home. Many people find themselves in situations in which selling their house would not generate enough money to pay off the home equity loan after payment of the first mortgage and closing costs.
Home equity loans can be beneficial in the right situation, but people should always consult with an attorney before using their home as collateral and potentially creating a bigger problem in the long term.
Credit Card Balance Transfers
Balance transfer offers usually advertise a dramatically-reduced introductory interest rate for people who are willing to transfer their credit card balances onto a new credit card. Additional credit cards, however, are rarely the answer for managing debt. In fact, they usually exacerbate the problem. Many people keep their existing credit card accounts open, incurring even more debt. A balance transfer ignores the root of the problem: insufficient income to manage existing debt. In contrast, Chapter 7 and Chapter 13 bankruptcies are effective because they address the cause of peoples' financial problems by eliminating or reducing the total amount of debt.
The pitfalls of balance transfers are usually found in the small print. Low introductory interest rates are used to lure people into transferring their balances onto one credit card, and often seem so appealing that the hidden costs and fees are hard to find or understand. The low interest rate usually lasts for only a limited amount of time. At the end of that period the introductory interest rate rises, sometimes to a higher rate than that of the original credit card. The low introductory rate period is often cancelled if the borrower makes any late payments on the account. The interest rate offered may only be applicable to balance transfers, and a different interest rate will be applied to all cash advances and purchases. Usually, payments made will be applied to the lower balance first, leaving the balances with the higher interest rates continuing to rack up interest.
The costs involved with a balance transfer can quickly cancel out any financial gain from a low introductory interest rate. Common fees include monthly finance fees, annual fees, balance transfer fees, cash advance fees, over-the-limit fees and convenience check fees. Borrowers often end up paying more in fees than the amount they are saving with the lower interest rate. The lenders also frequently push expensive add-ons and profit boosters, like credit protection insurance, which can cost as much as $45 a month. The fee is often charged up front, meaning the borrower is required to pay the interest each month on the extra amount.
Frequent balance transfers often damage a person's credit score. The increased activity can make a person appear to be a credit risk, and having too many active accounts can be derogatory to a person's credit score.
So, think twice before transferring balances from one credit card to another. Examine all of your options and speak with your attorney before making a financial decision that could have long-term detrimental implications.
Debt Consolidation Loans
Debt consolidation loans are personal loans that allow people to consolidate their debt into one monthly payment. The payments are often lower because the loan is spread out over a much longer period of time. Although the monthly payment may be lower, the true cost of the loan is often dramatically increased when the additional costs over the term of the loan are factored in.
The interest rates on personal debt consolidation loans are usually high, especially for people with financial problems. Lenders frequently target people in vulnerable situations with troubled credit by offering what appears to be an easy solution.
Personal debt consolidation loans can be either secured or unsecured. Unsecured loans are made based upon a promise to pay, while secured loans require collateral. Upon default of the loan payment in a secured loan, the creditor has a right to repossess any of the items listed as collateral for the loan. Title loans are an example of secured loans, where an automobile's title is listed as collateral and the borrowers must pay off the loan to reacquire their title. Some creditors require borrowers to list household goods in order to obtain a debt consolidation loan. The creditor has a right to repossess these items upon default of the loan payments. In many states, a person filing bankruptcy can remove the lien on the household goods listed as collateral and eliminate the debt.
Be careful about putting up your valued property as collateral. With high interest rates and aggressive collections, you might find yourself scrambling to save your car or personal property.
Credit-Counseling Agencies
One of the most significant changes under the Bankruptcy Reform Act of 2005 is a requirement that debtors, prior to filing for bankruptcy, would have to seek credit counseling. This is alarming to many critics who point out the challenges that millions of Americans face, who are already in credit-counseling.
Many credit-counseling agencies derive significant revenue from the credit card companies. The agencies make the majority of their income collecting fees from creditors on whatever their clients repay. For this reason, some credit counseling agencies, such as Ameridebt, have been accused of keeping their clients paying their creditors in a consolidation plan rather than filing for bankruptcy, even if a fresh start is in the debtors' best interests. The monthly fees can be steep, sometimes as much as 10% or more of the payment, and some agencies take the entire first payment as a "voluntary contribution."
The allure of a "non-profit" organization may cause some debtors to have the misconception that the agencies are not charging any fees for their services. In fact, the executives of these agencies can have annual salaries of hundreds of thousands of dollars and still retain their non-profit status because they operate in the public interest. Some agencies derive additional revenue by referring potential clients into deals with other companies who sell other products or offer home equity loans to debtors that require a lien to be placed on the borrower's house. Many people aren't aware of all the fees involved until they have already spent several months making payments through the plan.
The fees charged by credit-counseling agencies might be acceptable if the agencies' results are beneficial. However, you must carefully evaluate a credit-counseling plan, before joining, to make sure that it will actually improve your financial situation. Some agencies have been shown to neglect making timely payments, or even miss payments entirely, and sometimes aren't able to make deals with all the creditors. Not all agencies are guilty of these problems, but you must be careful to investigate an agency's background before joining the program.
Credit-counseling agencies usually won't consolidate debts that would not be dischargeable in a bankruptcy anyway, such as student loans, child support, and IRS debt. Instead, they devote your money to paying debts that would be dischargeable in a bankruptcy, and do not provide relief from the debts that cannot be eliminated. Even the best credit-counseling agencies usually aren't able to obtain the extensive relief from all of your debts provided by Chapter 13. A Chapter 13 bankruptcy plan includes all types of debt, even debts that are non-dischargeable in a Chapter 7.
A good credit-counseling plan can be beneficial if it is set up properly, the payments are manageable and the company administering the plan is reputable. The only way to make sure that you are using the solution that is most appropriate for you is to get educated about your options. Speaking with an attorney, who has a legal and ethical obligation to give you unbiased and useful advice is a great start to making this difficult decision. The attorney can help you determine if you can afford a debt consolidation program and if it is in your best interests.
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