Many people confuse refinancing with debt consolidation. Some of this confusion comes from the fact that people will refinance their home and do a debt consolidation at the same time. Understanding the difference and the pros and cons of each will help you choose the right option for your situation.
When refinancing a loan, the person changes the terms of the loan. Many people choose to refinance in order to lock in lower interest rates and may choose a shorter term or smaller payments. The refinance will pay off the original loan completely and you will receive a new payment schedule and payment amount. The advantage of refinancing is the potential to save money on interest and by shortening the term of the loan. If you extend the loan, you may pay more in interest, since you will be paying on the loan for a longer period of time. Many people will refinance their home when they find a better interest rate.
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Debt consolidation is when you take out a loan to pay off several loans and consolidate the monthly loans into one payment. Some people will do this by taking out a second mortgage on their home and cash out the equity they have built up. This will tie the debt to their house and put it at risk if they were to default on the loan. Another option is take out a signature loan, or unsecured loan, to consolidate the debt. Although the interest rate may be slightly higher, it does reduce the risk of losing your home.
Debt Consolidation with a Refinance
Often when people choose to refinance their first mortgage because of good rates, they will take a larger amount then what they still owe and use it to pay off other debts. This makes it possible to consolidate and refinance at the same time. The biggest disadvantage of this is that you are moving unsecured debt, such as credit cards, to secured debt. This means you are guaranteeing you will pay it off with your home. If you lost your job or were unable to work and couldn't pay the entire amount, you could lose your home. However, if your mortgage is separate from your other debts, you can choose not to pay the other debts in order to keep your home.
Choosing Between Refinancing and Consolidation
Refinancing your home to a lower fixed interest rate can save you money on your mortgage. It also can help you pay off your home more quickly. Consolidation can make it easier to manage your monthly payments and lock in a set interest rate, which is usually lower than your credit cards. If you are considering doing both, try to keep the consolidation separate from your home. Avoid doing a consolidation that will tie the debt to your home, since it can put your home at risk.