Getting out of debt often requires some type of debt consolidation loan. People that are in over their heads may feel like they are drowning. Instead of letting the debt go, they take out debt consolidation loans. Essentially, it’s one large loan that pays off multiple debts. You then have one payment you make each month. This is different from debt settlement. You still have a loan you must pay.
There are pros and cons to debt consolidation loans. In this guide, we’ll break down each option and look at their advantages and disadvantages.
The Types of Debt Consolidation Loans
You have two options with debt consolidation loans:
- Secured loans
- Unsecured loans
Secured loans have collateral. For example, a mortgage or auto loan is a secured loan. If you default on the loan, the lender takes your collateral. Unsecured loans have no collateral. Credit cards and personal loans are two good examples. If you default on either one, the lender has nothing to take. They can file a judgment against you, but that takes time. Each loan has its pros and cons. We look at them below.
The Pros of a Secured Loan
First, let’s look at the secured loan. We’ll use a home equity loan as the main example. Generally, a secured loan has a lower interest rate. Lenders increase interest rates based on risk. If there is collateral for the loan, though, the lender doesn’t carry as much risk. In turn, they offer a lower interest rate. Lenders also often have more lenient guidelines for qualifying for a secured loan. Again, because they have the collateral to fall back on, they can take riskier prospects.
As a bonus, homeowners can often deduct the interest they pay on a home equity loan on their taxes. This can decrease your tax burden. This furthers the benefit of consolidating with a secured loan. This only pertains to loans tied to your home, though. If you use any other collateral, such as your car or 401K, you can’t write off the interest.
The Cons of a Secured Loan
The largest downside of a secured loan is the collateral you put at risk. Let’s say you wrap your credit card debt into your home equity loan. If down the road you have trouble paying the loan, you put your home at risk. Remember, this was for your credit card debt, not the money you needed to purchase the home. The same is true for any other collateral you use for a secured loan.
Secured loans often have longer terms as well. This means it takes you longer to pay the debts off. The longer you borrow money, the more interest you pay. Even with identical interest rates, you pay more interest on a 10-year loan than you would a 5-year loan. Home equity loans often have a 20-year term. That’s a long time to drag out your credit card or other consumer debt. If you pay too much interest over the life of the loan, it may not make sense to consolidate your debt. Make sure you look at the big picture before making a decision.
The Pros of an Unsecured Loan
Unsecured loans aren’t as common. Only consumers with excellent credit may qualify. With nothing to fall back on, lenders have to make sure you are worthy of the loan. If you qualify, you stand to reap many benefits. The most common type of unsecured loan is a credit card. But, some consumers can get a personal loan with no collateral.
First, you don’t put your home at risk. That’s a large benefit when you consolidate your debt. Usually, lenders want to see some type of guarantee of payment. With great credit, though, you may not need it. This is common for no-interest credit cards. Borrowers with excellent credit may qualify for a 0% APR credit card with balance transfer options. This allows the chance for debt consolidation without putting any assets at risk.
If you snag a 0% APR credit card, you can save a lot of money on interest. Even personal loans don’t have high interest rates. The interest charged is often much less than the combined interest you pay on multiple credit cards now.
The Cons of an Unsecured Loan
If you compare an unsecured loan to a secured loan, you’ll pay higher interest rates than a secured loan. If an unsecured loan is your only option, though, it doesn’t matter. Lenders take a higher risk with an unsecured loan so they charge more. If they don’t charge a higher interest rate, they may charge other fees. They include balance transfer fees, origination fees, and closing costs.
The terms of a 0% APR credit card may limit your savings as well. If you use available credit for any other purchases, they may accrue interest. The payments you make, however, are generally applied to the no-interest balance first. This may end up costing you more in the long run as your interest accrues.
The Pros of Debt Consolidation in General
Debt consolidation often helps borrowers get out of a hole. If you can’t keep up with your payments, consolidating your debt may help. Having just one payment to focus on each month makes it easier to keep up. It also makes it easier to make extra payments when you have the funds. If you have multiple debts, it’s often hard to figure out which debt you should pay first. With one loan, the answer is simple. The more you pay, the quicker you get out of debt.
In general, you should have a lower payment too. Combining all of your debts into one loan may give you a lower average interest rate. This means a lower payment, which gives you more money in your pocket. With the stress of multiple payments gone, you can focus on getting your debt paid down or off.
A debt consolidation loan can save your credit if you are about to default. The loan brings your debts together and pays everything else off. You now have open credit lines with no balance. This may help your credit score. It is certainly better than defaulting on your loans and ruining your credit.
The Cons of Debt Consolidation in General
Debt consolidation opens the door for more turmoil if you aren’t careful. We touched on this above, but it’s worth repeating. You must change your habits before you consolidate your debt. If you continue charging things you can’t afford, you’ll end up right where you started. Tuck your credit cards away and sock away any savings you reap with the lower monthly payment.
You may also pay more interest in the end. For example, if you choose a home equity loan with a 20-year term, you stretch your payments out over 20 years. This means you pay interest for that entire time. If you add up what it would cost you to pay the interest over that time, you’d see that you aren’t saving anything in the end.
Last, the wrong type of debt consolidation can ruin your credit. For example, a new credit card with a high balance can negatively affect your credit score. A new installment loan can also bring it down, at least initially. The worst-case scenario, however, is when you use a debt consolidation agency to negotiate your debts for you. If your creditors write off a portion of your debt, they may report it as a charge off. This can negatively affect your credit score.
The Final Word
Debt consolidation loans often help you get back on track. They can help you prevent default on your loan. They may also help you increase your credit score. Just make sure you read the fine print. Whether you use a bank for a personal loan or you take out a new credit card. Understand the fees and the terms of the loan. Make sure you can afford the new payments and don’t rack up your credit cards any more than necessary. This way you can put the days of being in debt behind you.