Dangers of Consolidation Loans

If you need money, getting a consolidation loan is usually not a good idea. Here's why.

Some bank subsidiaries and consumer finance companies lend money in the form of consolidation loans. With a consolidation loan, you pay off several loans or debts by taking out one new loan. A consolidation loan can be secured (meaning you pledge some property as collateral to guarantee payment) or unsecured. In many cases, both secured and unsecured consolidation loans are a bad idea. Here's why.

(To learn about other options to avoid when you are trying to get some cash, see Options to Avoid When You Need Money.)

Secured Consolidation Loans

Finance companies make secured consolidation loans, usually requiring that you pledge your house or car as collateral. These loans are just like second mortgages or secured vehicle loans. (To learn more about secured loans, see What Is a Secured Loan?)

Here are some of the dangers of secured consolidation loans:

  • High interest rates. The amount of interest you may be charged on a secured consolidation loan can vary greatly, from about 10% to more than 36%, depending on your credit rating and the security.
  • Little information about rates. Those offering consolidation loans are often unwilling to provide you with interest rate information until you fill out an application, making it difficult to comparison shop. If you are considering a consolidation loan, tell the lender that even if you provide answers to their questions, you do not want to have an application submitted until you get information about the interest rate.
  • You could lose your home or car. If you pledge your property (such as your home or car) as collateral for the secured loan and you default on the loan, the finance company can foreclose on your home or take your car or other property.
  • Interest payments may not be deductible on your tax return. If you’re considering a consolidation loan secured by your home, understand that the interest payments may not be deductible, unlike the original loan on your home. Ask a tax professional about deductibility if any of the following is true: the loans on your house will total more than your house is worth; you want to use $100,000 or more of the loan money on something other than your house, or you are subject to the alternative minimum tax.

Unsecured Consolidation Loans

Finance companies and similar lenders also make unsecured consolidation loans—that is, they lend you some money without requiring that you pledge any property as a guarantee that you’ll pay. But the interest on these loans often reaches 35% or more. They also charge all kinds of fees or require you to purchase insurance, often bringing the effective interest rate closer to 50%.

Protect Yourself

If you still want to take out a consolidation loan, you are better off borrowing from a bank or credit union than a finance company. Many finance companies engage in illegal or borderline collection practices if you default and are not as willing as banks and credit unions to negotiate if you have trouble paying. Furthermore, loans from finance companies may be viewed negatively by potential creditors who see them in your credit file.

This is an excerpt from Nolo's Solve Your Money Troubles: Debt, Credit & Bankruptcy, by Amy Loftsgordon and Cara O'Neill.

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