Trading Unmanageable Debt for Manageable Debt

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Trading Unmanageable Debt for Manageable Debt

If you are like many people who find themselves with too much debt, you may need to consider refinancing or consolidating your loans. You might find yourself in a predicament where no matter how hard you try, you just cannot cut expenses any further or earn more income. The only solution is to lower your monthly debt payments.

There are only three ways to lower monthly debt payments: reduce the principal amount, get a lower interest rate, and extend the payments over a longer term. These three principles are used in refinancing and debt consolidation. Let’s see how these work and then look at the advantages and disadvantages.

Refinancing: changing the principal, interest, and payback period

Refinancing debt means simply changing the terms of the debt agreement. This means that an old debt is replaced with a new debt, usually for the same amount, but with different repayment terms such as a new interest rate and repayment period. Refinancing can help those who find themselves with excessive debt because it allows a loan to be repaid with lower monthly payments. Monthly loan payments can be reduced if a loan is refinanced with either a lower interest rate or longer payment period, or both. This is clearly an advantage to those with a cash flow problem. An advantage to a lower interest rate is that the cost of borrowing is lowered as well. A longer payment period generally costs more for the borrower, since the interest payments stretch over a longer term—hence a more costly loan. Refinancing may involve costs that need to be considered as you determine whether refinancing is the right choice for you.

Advantage of secured long-term debt

There are many reasons why some loans have lower interest rates than others. Long-term loans generally have higher rates than short-term loans. Secured loans also have lower interest rates than loans for which there is no collateral. A mortgage, for example, is a long-term, secured loan. If you follow mortgage rates, then you know that they are lower than the rate for an unsecured personal loan from your local bank or finance company.

The problem with unsecured short-term debt

Many persons with excessive debt usually have many short-term unsecured loans or credit card debts with high interest rates. This puts a burden on the family finances because there are too many monthly payments, leaving little left to pay for ordinary family expenditures. If these people refinanced their loans, they might be able to reduce their monthly payments so they could better manage their finances. One must be careful, however, to avoid stretching payments so long that doing so increases the cost of goods too much. For example, if you bought a TV for $1,000 with a revolving line of credit at 12% and paid it off in 12 months at $89 per month, the net cost would be $1,066. That might be reasonable, especially if you got a good deal on the price to start. However, if that loan was refinanced to 60 months at $22 per month, the cost would go up to $1,335—not such a bargain.