Credit 201: “Debt Consolidation – Part 1 – Things You Should Know”

If you’d like to skip ahead to find out what to do about your debt CLICK HERE to read Part 2!

So often someone applies for a Debt Consolidation loan too late. Their score has dropped due to high balances on credit cards and, sometimes, the weight of the debt has caused them to not be able to make some payments so they are also now behind.  Successful consolidations are rarely One-Hit-Wonders, meaning they usually take a few initial steps in order to increase your score / lower your debt-to-income before an amount adequate enough to payoff all of the debt can be approved.  I will outline some of the key elements that lenders use when addressing an application for Debt Consolidation, and then I’ll help you to reverse-engineer your own situation to increase your chances of approval. 

How Lenders Decide What Amount to Give:

Most lenders have guidelines in place that help them to determine what amounts they can give to a person for any given loan. In the case of a collateralized loan (a loan secured in some way, whether by a vehicle, property, or cash) the lender usually considers first the value of the collateral being borrowed against and makes sure that the payment itself is affordable for the borrower to repay. However, when most contemplate consolidating high interest credit card balances and personal loan payments, their first thought is to apply for one big personal loan to pay off everything. This would be ideal, but the problem with this thought is that if the score is low or the DTI is too high, the lender may be forced to counter-offer a lower amount.

With that in mind, key elements that these lenders look at are a person’s level of income, their credit score tier, and the amounts of unsecured debt they either already have, have had, or will still have leftover once the consolidation is complete. Many lenders like to see a person take baby steps in the amounts they borrow, smaller to larger, then larger and larger; but not huge amounts right off the bat. They may even prefer to know that you will be closing down some of your extra cards in an act of good faith in your promise to be using the loan to become free of debt. Although closing older tradelines may cause your score to take a hit, having too many open revolving accounts is a red flag to future lenders. I once helped a couple consolidate 27 credit cards and personal loans, 27 separate accounts! Each account had its own minimum payment and those alone added up to nearly $2000 a month in payments.  At that point, taking a small ding for closing out a chunk of these accounts was not a bad thing. 

Loan Types for Consolidations:

Personal Loans: often referred to as Signature Loans – because a lender truly only has a signature as promise of repayment with nothing to recoup if the borrower defaults on what’s owed – are perhaps the riskiest loans that a lender can give. Therefore, if someone has the Score and Income to qualify for say, $15,000 in unsecured loans with a lender, that lender may still ask themselves, “Has this person ever been given that sizable of a loan before? What exactly are they paying off using this loan? Will this loan truly reduce their monthly obligations or simply add to it?”

Lines of Credit are another common type of unsecured loan; one which typically offers a lower interest rate than its counterpart (the counterpart: signature loans and balance transfers to credit cards). Think of a Line of Credit as a Credit Card without the piece of plastic to carry around as temptation to use. From the lender standpoint, a Revolving Line of Credit is something that can be used again and again and is therefore more risky than a personal loan, which would act as a single lump sum. I’ve seen successful consolidations take place when using a Line of Credit to payoff high interest balances, but if you are not aware of your Total Revolving Limit Utilization Percentage you could temporarily cause your credit score to plummet. So, if you are considering using this type of loan product to consolidate debt, be sure to add up your balances on items with limits, and then add up your new total credit limits (or what they’ll be once the new L.O.C. is added) and make sure you will not be exceeding 50% Credit Limit Utilization or your score will suffer. 

Home Equity Lines of Credit (HELOC’s) are a great tool for consolidating debt if you are careful to fully understand how they operate. Each institution has it’s own tweaks on how theirs functions but the general principal is the same. The Lender assesses the value of your home, often through an appraisal, and using a percentage of that value (usually 90% LTV) subtracts what you currently owe on your primary mortgage, if at all. What remains tells them what usable or available equity you have in your home. [Click here to read more about Home Equity’s on the Consumer Financial Protection Bureau’s website]

Home Equity Loans are not the same thing as Cash-Out Refinances. A Home Equity loan is a loan in addition to your primary home mortgage. Ergo, they are referred to as a type of 2nd Mortgage, since your primary mortgage remains in the 1st position. A Cash-Out refinance is when someone refinances their primary mortgage by paying it off and increasing the borrowed amount in order to take “cash-out” equaling the difference. 

In the case of Home Equity Loans there are 2 main types, but I prefer the Revolving type in which the lender sets up a reusable line of credit not totaling more than the applicant’s available equity on their home. These often have a super low, albeit variable, interest rate that follows the Wall Street Journal Prime Rate, and most of them operate with interest-only minimum payment obligations during the first 10 years of their inception, which can really allow for a lot of flexibility in what you pay. If that person pays more than the minimum then all the extra pays down the principal balance.  I do not recommend this product to someone who can only pay the minimum of interest-only though since this means they would not have anything going toward the principal and if rates were to increase they would not be able to afford the payment. This would result in what’s called reverse amortization which is incredibly counterproductive.

Easy Available Equity Calculation for LTV of 90%: 

[ (Estimated Home Value X .90) – Current Mortgage Balance ] = Available Equity. 

For Example: 90% of a home valued at $265,000 woul d be $238,500. So if the mortgage was still $195k then the person has $43,500 in available equity, and could therefore get a HELOC Limit of about $43k.

Cash-Out Refinance on Collateral: One final way of paying off and consolidating is by taking a loan out against some form of collateral. Unless the amount is extreme ($40k or more) then I do not normally suggest a Cash-Out Refinance of a mortgage. Especially if the rate on said home mortgage would have to increase. The concept here is that the lender will first assess the value of the collateral in question in order to determine what they overall Loan-to-Value will be. The most typical form of collateral for this type of transaction is a motor vehicle.

For an in depth look into Loan-to-Value, read: Credit 201 – Loan-to-Value

Most financial institutions have rules as to what someone’s maximum loan to value may be on each type of collateral depending on factors like the age of the collateral or the person’s credit tier. Typically, the higher someone’s credit score the higher the amount of Loan-to-Value they are allowed to have. What this means for a cash-out refinance is that there are more dollars given for the loan.

For example: imagine 3 different people applying to payoff $12,000 worth in credit card debt. Each of them have vehicles that are less than 4 years old with Clean Trade values of $15,000 which they still owe roughly $8,500 on.

• Julie has an A+ credit score (720 or higher) allowing her to borrow up to 140% LTV with her bank (140% of $15,000 is $21,000). So taking $21,000 – her payoff of $8,500 would allow her to get as much as $12,500 more as cash out and she only needs $12k to payoff all of her cards.
• Jason has a B Tier credit score (650-689) so his bank would possibly allow him a max of 130% LTV (130% of $15k value would be $19,500). So after subtracting his payoff of $8,500, he would be allowed to take another $11,000 as cash-out to pay towards his cards. This would still leave him owing $1,000 on his card balances, but he certainly would get most of it paid off.
• Finally, Jamie has a D Tier credit score (619 or lower) so her refinance was approved with a limited LTV maximum of 100%. This means that Jamie can only borrow as much as the exact value of her vehicle, $15,000. After refinancing her $8,500 loan she would only be able to tack on another $6,500 which would still leave her card balances at $5,500. 

For Next Steps CLICK HERE to Read: “Debt Consolidation – Part 2 – Strategy”

Your Friendly Neighborhood Banker,

Josh Romine