Simply stated, debt consolidation is “the act of combining several loans or liabilities into one loan. Debt consolidation involves taking out a new loan to pay off a number of other debts. Most people who consolidate their debt usually do it to attain a lower interest rate, or the simplicity of a single loan.” See http://www.investopedia.com/terms/d/debtconsolidation.asp#axzz2FNj7RySE
The most typical example of this is where someone has high interest rate credit cards. If the debtor has enough equity in his/her home, the debtor will take out a home equity loan or loan from their 401(k) or IRA and use the proceeds to pay off their debts. The debtor must then repay the loan, usually at a much lower interest rate than the credit cards.
The advantage of this is that the debtor who can qualify for a lower interest rate can use the funds to pay off higher interest rate credit cards. Another advantage is that life is a little simpler as the debtor now just has one bill to pay rather than several. However, I am not a fan of this method of debt resolution. For one thing, where someone is borrowing equity from their home, they are taking unsecured debt and turning it into secured debt. We are living in uncertain times and many of us are just one paycheck away from losing a job. If any calamity – whether medical or job-related happens, what then? A debtor with a home equity loan is at risk of losing the home if payments are not made.
Moreover, home equity loans are not as prevalent as they once were prior to the 2007-2008 economic meltdown. Lenders now have more stringent standards and for people with credit issues and less than stellar credit scores, these kinds of loans may be very difficult or impossible to obtain. Not to mention the fact that housing values in some areas of the country were part of the housing bubble in that their values were inflated. When the bubble burst, many people found themselves without any equity to tap. Housing values still have not recovered sufficiently so as to allow debtors to start treating their homes as ATM machines again.
Borrowing from a 401(k)/IRA has somewhat similar consequences. These investment vehicles are there to provide for retirement and be a supplement to Social Security. Again, I am not a tax lawyer, but there are tax consequences if withdrawals are made from an IRA prior to age 59 ½ and there is no other exception. Consequently, a debtor who withdraws funds from a traditional IRA will not only have to pay tax on the money but will also have to pay a penalty if below the age for withdrawal. For 401(k)s, these loans must be repaid or else the debtor will be subject to taxation too.
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