The Center For Debt Management
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Your Alternatives When Faced With Financial Hardship

—Article by Daniel Gelinas

... Continued From Previous Page

Second Mortgage Loan and
Home Equity Line of Credit

Everything mentioned in the preceding regarding debt consolidation loans apply here as well. In fact, a debt consolidation loan is typically nothing more than a second mortgage, often called a home equity loan. A debt consolidation loan, however, need not necessarily be a home equity loan.

A home equity line of credit and a second mortgage both use the equity in your home as collateral. A home equity line of credit provides, you guessed it, a "line of credit," and only when funds are drawn from it do interest charges accrue and payments begins. In contrast, a second mortgage loan typically provides the borrower with a "lump sum" of money. Interest is charged on the entire amount borrowed and monthly payments begin immediately. Both types of loans may require processing fees, an appraisal fee and possibly other costs.

The apparent interest rate of the loan may seem reasonable (and it may be), however, after factoring in all of the costs of getting the loan, the actual annual percentage rate may increase substantially. Even so, the net result could end up with a better interest rate than your current average interest rate of the debts you intend to pay off — if that is what you intend do with the proceeds! On the other hand, depending on many factors, including your credit worthiness and equity, the cost of processing the loan and resulting monthly payments might not provide you with any relief at all.

The problem most debtors have — is not having enough equity in the first place. Typically, lenders use a formula for determining eligibility and how much they will lend. This is usually based on a percentage — from 50% to 80% of the current market value of the home, less the amount that is still owed on it. If the current market value is appraised at $100,000, lenders will typically lend $50,000 to $80,000 maximum — that is, if you own the home free and clear. If the amount owed is $75,000 and the home owner is able to find the right lender, he or she may get a $5,000.00 loan. Of course, after paying the processing fees and other costs, they may, in effect, only get a portion of this amount.

The advantage of a second mortgage or a home equity line of credit is that the interest may be tax deductible for tax payers itemizing deductions. Therefore, one must take this aspect into consideration and analyze the net result after taking this deduction. It may be wise and prove beneficial to discuss this issue with an accountant.

Whether a second mortgage or home equity line of credit is right for you depend on many factors, but generally you need a fair amount of equity in your home to make it worthwhile. Also, as noted under "Debt Consolidation Loan" there are many risks and concerns that must be considered. In particular, should you default on the loan, you could end up losing your home. If the purpose for acquiring the loan is to consolidate primarily "unsecured" debt, you are well advised to give it serious thought.

A better option may be to borrow just enough to pay off "secured" debt, and perhaps certain unsecured accounts that are likely to result in legal action should the debtor default. This should lower the debtor's overall monthly debt service and reduce the risk of defaulting on the remaining debts. Should the debtor later run short of funds, the debtor could then take funds from the budget allocated for the remaining unsecured debts to make the newly acquired, and all-important second mortgage or home equity line of credit payment. While doing so would place the unsecured account(s) in jeopardy, such action could, as they say, save the farm!

If a debtor has significant secured debt and unsecured debt, another option that may be available is to obtain a home equity line of credit or debt consolidation loan to consolidate "secured" debt and then seek a debt reduction settlement or enroll in a debt management program to consolidate "unsecured" debt. For heavy debtors this is an extremely viable option that provides a safety factor and could yield significant savings in interest charges, late fees and other charges.

One of the more effective uses of a home equity loan is when the funds are used to negotiate a Debt Reduction Settlement, which can not only settle unsecured debts, but in some cases, secured debts. Depending on the particular circumstances, this could be a very worth while option and can often slash a debtor's overall debt in half.

Notice: Using funds from a debt consolidation loan, second mortgage, home equity loan or line of credit to pay off unsecured debt should ONLY be done when it results in significant savings, and the effect of it resolves your financial hardship. You should be reasonably certain that you will never default on the obligation. Otherwise, it is not practical and financially sound to convert unsecured debt to secure debt and risk losing your home!

Refinancing

Refinancing can be a great way in which to reduce debt, however, whether it's effective depends on how favorable the current Prime Rate is—the rate in which the FED lends money to its most favored financial institutions. For example, at the time of this writing the Prime Rate was 4.5%, which is considered low and presents a great opportunity for many homeowners to refinance their home, regardless whether they are in debt or not.

Depending on the amount of equity in the home, debtors may be able to refinance for more than their current mortgage and use the extra funds to pay off debt. This can be extremely effective when used as part of a Debt Reduction Settlement.

Let's look at some examples:

Bill and Mary own a home valued at $250.000. They have a first 30 year fixed mortgage at 7.5% (with about 27 years remaining) and a second 15 year fixed mortgage at 8.5% (with about 13 years remaining). Their combined mortgage payments total approximately $700 per month and their combined mortgage balance is approximately $88,000. Bill and Mary learn that they can refinance their home with the proceeds of $88,000 used to pay off both mortgages. They elect to get a 15 year fixed mortgage at 6.25%. The cost to refinance is $600 and their new mortgage is now $733.

In the above scenario it will increase Bill and Mary's monthly mortgage payment by $33. However, their home would now be paid off in 15 years instead of 27 years. Had they not refinanced, they would have paid $83,160 in interest on their remaining balance. With their new $88,000 mortgage, they will now only pay $44,000 in interest, a substantial savings considering that the extra $33 per month will only cost them $6,000 during the 15 year time span. Bill and Mary's total savings amount to $32,560.

Now let's suppose the same scenario, except that Bill and Mary are $50,000 in debt and they elect to get a 30 year fixed mortgage at 6.75%. Their mortgage payment would now drop to $500 and their total interest paid would amount to $92,070. Bill and Mary will now have $200 extra per month to help pay down their debt. While they will now pay some $8,910 more in interest had they not refinanced, the fact is, with a $200 reduction in their monthly mortgage payment, they will now pay $31,200 less over the term of the mortgage. Thus, overall they save $22,290. By using the $200 each month to pay off high interest debts, they would save thousands more!

Let's take it another step. The same scenario as the last, however, this time Bill and Mary opts to borrow an extra $50,000 to completely liquidate their high interest debt. They now refinance for $138,000, taking out a 30 year fixed mortgage at 6.75%. Their new mortgage payment is now $784 with total interest amounting to $144,382.

Whoops! Did Bill and Mary make a mistake? Let's take a closer look!

Bill and Mary owed $50,000 with an average interest rate of 18%. Their creditors required a minimum monthly payment of 2%, which means their current balance of $50,000 would require a payment of $1,000. Of this $1,000, $250 would go to principle and reduce their balance to $49,750, that is, assuming there are no late fees or overlimit fees. $750 of the payment would go to interest. Bill and Mary's next payment would be reduced to $995.00, with slightly more going to pay off principle and slightly less going to interest. This process would continue until the debt is liquidated.

How long would it take to liquidate the debt making minimum payments? It would take 601 payments, a span of 50 years, and total interest of $142,625.

Had Bill and Mary not refinanced and paid off their $50,000 high interest debt, they would have paid some $225,785 in combined interest to liquidate their debt and amortize their mortgage. By refinancing they eliminated their monthly debt payment altogether, however, they had to increase their mortgage payment by $84. Thus, in the span of 30 years, would pay $30,240 more in mortgage payments. If you add that to their total mortgage interest of $144,382 which equals $174,622 and subtract it from $225,785, Bill and Mary saved $51,163 by refinancing. And probably thousands more considering that they may have had to pay multiple late fees had Bill and Mary not taken corrective action to reduce their monthly debt service.

Could Bill and Mary have done better? Possibly. Depending on circumstances, they may have been able to accomplish a Debt Reduction Settlement, saving them anywhere from 20% to 80% off their $50,000 debt. In a typical Debt Reduction Settlement resulting in a 50% savings, they would have settled their debt for $25,000. Therefore, Bill and Mary would have only needed to refinance $113,00, instead of $138.000. That would have resulted in a mortgage payment of $642.00 and total interest of $118,226. In addition to paying $26,156 less in interest, they would have reduced they mortgage payment by $142—a savings of $51,120 over the term of the mortgage. They would have saved in additional $77,279, for a total savings of $128,439.

Notice: Refinancing to pay off unsecured debt should ONLY be done when it results in significant savings, and the effect of it resolves your financial hardship. You should be reasonably certain that you will never default on the obligation. Otherwise, it is not practical and financially sound to convert unsecured debt to secure debt and risk losing your home!

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