Debt is an unfortunate fact of life for many of us. Unless you already have tons of cash lying around, chances are you’ll need to take out debt at some point in your life, whether it’s to buy a house, purchase a new car, or go to college. Once you are carrying a liability on your personal balance sheet, however, it’s important to manage it effectively so it does not become a severe hindrance to your monthly cash flow or ability to continue making progress towards your long-term financial goals. This is especially true for “bad”, unsecured debt, such as credit cards or personal loans that are not backed by any assets and can carry very high interest-rates capable of costing you thousands of dollars per year in interest. Fortunately, there are a couple strategies, namely refinancing and consolidation, that can help you take control of your debt situation while saving you money in the process. Let’s take a look at debt refinancing vs. consolidation.
What is refinancing?
Refinancing is simply the replacement of an existing loan with another loan under different terms. There are a number of reasons you might go the refinancing route. The most common reason is to take advantage of a better interest rate for a reduced monthly payment or reduced term. When the financial crisis hit in 2008, for example, and the Federal Reserve lowered the federal funds rate to an all-time low of 0.25% in December of that year, many homeowners who had bought pre-recession jumped at the opportunity to save money on their loans with lowered rates.
Another common reason you might refinance a loan is to reduce or alter the risk they are exposed to. This is frequently seen with borrowers looking to move from variable-rate loans to fixed-rate loans. As the economy has recovered since the recession, the Federal Reserve has gradually raised interest rates.
When rates were lower, you may have gone the variable-rate loan route as you were able to get lower rates than fixed-rate loans. However, holding a variable-rate loan in a rising interest rate environment means you have no protection or guarantees against your interest costs. This can end up being far more expensive than you ever expected or intended. This is why so many borrowers who find themselves in this kind of situation will refinance to fixed-rate loans simply for the protection, even if it’s a higher rate than what they were originally paying.
What is consolidation?
Debt consolidation is technically a form of refinancing, but its primary purpose is to combine multiple loans into one loan, as opposed to strictly seeking better loan terms. It’s a tactic generally employed when you have multiple loans with differing interest rates and payment amounts. Not only can having multiple loans at different rates be very expensive, it can also be quite overwhelming and difficult to manage from a cash flow perspective. As a result, you might consolidate each of your loans into one big loan with one interest rate and one monthly payment. This can help secure a lower overall interest rate on the entire debt load and offer the convenience of only one monthly payment.
You should be aware, however, that consolidation is restricted to debt types. Meaning, you can’t take a mortgage, a student loan, and credit card debt and consolidate it into one loan. This is because not all debt is treated equally. Some debt obligations, like mortgages, are backed by tangible assets, while others, like credit cards, are not. There’s also differing tax treatments for each type of debt. Interest paid on mortgages and student loans, for example, is tax deductible, while credit card interest is not.
Assessing the risks involved
Refinancing or consolidating debt, as advantageous as it can be, is not without its risks. There is always risk involved in borrowing money, but there are a few specific risks to pay attention to before you decide if refinancing or consolidating is right for you. First of all, it’s important to know where interest rates are headed. Are interest rates on the rise or are they being slashed? If you took out a loan when rates were lower, but now they are drastically higher, refinancing or consolidating could have the opposite effect intended and actually cost you more.
Second, it’s important to note the potential impact a new loan can have on your credit score. Every time you apply for a loan, the lender will perform a hard credit pull. This means it becomes a part of your official credit history and stays on your credit report for 2 years. An occasional hard pull is fine and minimally damaging to your credit score, but multiple hard pulls over a long period of time can do significant damage.
Third, you need to be aware of the impact your credit score can have on the terms of your loan. The better the credit score, the lower the interest rate. If you are trying to refinance to lower your rate but have a mediocre credit score, refinancing may not even be possible, let alone beneficial.
Lastly, you need to consider the terms available to you through refinancing if you find yourself in a worst-case type of scenario. What if you lose your job or end up disabled? These are rather macabre scenarios to think about, but they do happen and need to be considered. If you have federal student loans and find yourself in a financial hardship, for example, you have the ability to temporarily defer payments if need be until you can get back on your feet. With a private student loan, however, this may not be possible. This is why it is so important to thoroughly weigh your options before you make any decisions. It also helps to have an emergency fund built up, just in case. You never know when disaster can strike, but you can be prepared for it.
If you have more questions surrounding your own debt situation or how to best manage it, schedule a free consultation with us today. We’ll take a deep-dive look at your current financial picture and help you determine the best path forward.
Chad Rixse grew up in Anchorage, Alaska and lived in Seattle, WA for 11 years where he graduated from the University of Washington before moving back to Alaska. He is fluent in Spanish, loves to travel and connect with other cultures. He’s been helping clients plan for their financial futures since 2014 and has an immense passion for helping others and making a positive impact in their lives. Outside of work, he’s a self-professed golf addict, foodie, and master taco maker.