Debt Consolidation Loans: Pros and Cons

If you're considering debt consolidation, understand the advantages and disadvantages.

If you're thinking about ways to better manage your finances, like filing for bankruptcy or trying to settle your debts for less than you owe, you might also be considering debt consolidation. With debt consolidation, you get a single loan to pay off multiple other loans, leaving you with just one monthly payment rather than several. In theory, making one payment to one creditor each month will be easier to manage than paying several different creditors.

But is debt consolidation a good option for you? On the positive side, debt consolidation usually allows you to lower your interest rate and get a reduced monthly payment amount. On the negative side, you might have to put your home or car up as collateral, and you might end up paying more in the end. Debt consolidation has additional advantages and disadvantages, discussed in more detail below.

How to Consolidate Debt

To consolidate your debt, you get a single loan to pay off your other loans, leaving you to make just one payment to a single creditor each month rather than making multiple payments to multiple creditors. Consolidation loans are either "secured" or "unsecured."

What Is a Secured Loan?

When you take out a secured loan, such as a mortgage or a car loan, you pledge specific property, such as your home or your car, to secure the repayment of the debt. For example, when you get a mortgage loan, your house acts as security for repayment. If you fall behind in payments, the mortgage holder can foreclose on your house to satisfy the loan.

You have many options for consolidating your debt using a secured loan. You can refinance your house, take out a second mortgage, or get a home equity line of credit. You can also take out a car loan, using your automobile as collateral. Or you can also use other assets as security for a loan. A 401K loan uses your retirement fund as collateral. If you have a life insurance policy with cash value, you might be able to obtain a loan against the policy. A variety of financing firms will also loan you money against lawsuit claims, lottery winnings, and annuities.

What Is an Unsecured Loan?

Unsecured loans are based only on your promise to pay and aren't secured by any property that can be foreclosed or repossessed to repay the debt. Credit cards are examples of unsecured loans. Unsecured loans usually have a higher interest rate because they carry more risk for the lender.

Online lenders, banks, and credit unions offer unsecured personal loans that you can use to consolidate credit card debt and other kinds of debt. Also, some people use a no interest, or low interest, introductory rate on a credit card as a substitute for an unsecured personal loan for debt consolidation.

Debt Consolidation Through a Secured Loan

Proponents of debt consolidation often push it as a strategy for getting debt under control. They say it's an easy way to save money and protect your credit rating. But this tactic for managing your debts has drawbacks, too. Here are some of the pros and cons of getting a secured loan to consolidate your debts.

Pros of Debt Consolidation With a Secured Loan

Often, secured loans have lower interest rates compared to unsecured loans and credit cards, so you might save money on interest payments by consolidating through a secured loan. Getting a lower interest rate will also likely reduce your monthly payment and make it more affordable. So, a single monthly payment with a lower interest rate could ease your financial burden substantially. Also, secured loans are generally easier to obtain than unsecured loans because they carry less risk for the lender.

Cons of Debt Consolidation With a Secured Loan

But consolidating your unsecured loans into one secured loan presents a couple of huge downsides:

  • When you pledge assets as collateral, you're putting the pledged property at risk. If you can't pay the loan back, you could lose your house, car, life insurance, retirement fund, or whatever else you might have used to secure the loan. Certain assets, such as life insurance or retirement funds, might not be available to you if the loan isn't paid back before you need to use them.
  • Also, the term (the amount of time the lender gives you to repay the loan) of a secured loan might be longer than the term of the debt obligations you consolidated. So, the total interest that you pay over the life of the consolidation loan could be greater than the interest would have been on the individual debts, even though the monthly payment is lower.

Debt Consolidation Through Unsecured Loans

Although debt consolidation by taking out an unsecured loan has some advantages, it's not necessarily the best way to manage your debt problems. Consolidating could end up costing you more money, and another option might be more appropriate for your situation.

Pros of Consolidating With an Unsecured Loan

The biggest benefit to an unsecured debt consolidation loan is that no property is at risk. And, while the interest rate might be higher than a secured loan, it could be lower than what's charged on your different credit card balances or other loans, which lowers your interest burden and your payment.

Cons of Consolidating With an Unsecured Loan

An unsecured debt consolidation loan might not reduce your interest rate if you don't have good credit. Also, interest rates are generally higher than secured loans. So, the loan's rate might not be low enough to make a difference in your financial situation. And much like with a secured consolidation loan, the term of the loan might be longer than the term of the debt obligations you consolidated. So, you might end up paying more once you factor in all the interest, even though the monthly payment is lower.

Using balance transfer options on no-interest or low-interest credit card offers to consolidate debt is tricky. Often, you have to pay a transfer fee, which negates some of the savings. Also, the card's rules can diminish the benefits. For instance, if you use the card for anything else, the other charges might generate interest while payments are applied first to the no-interest balance. Also, the no-interest or low-interest period is generally limited. If you can't pay the debt off during this time, you might end up paying higher interest once the special offer period runs out.

The Psychological Pros and Cons of Debt Consolidation

While the benefit of consolidating your debts into one loan with one lower monthly payment might provide you with some emotional and financial relief, it could also leave you feeling prematurely confident about your financial situation. You might let your guard down and incur additional debt before you've paid off the consolidation loan, starting the cycle all over again.

How Debt Consolidation Affects Your Credit

Although a debt consolidation loan will likely show up as a tradeline on your credit reports, if you stay current on the debt, it won't typically lower your credit scores much, if at all, under most scoring models. But if you seek credit in the future, creditors that see a consolidation loan in your credit files might view it negatively because it implies prior debt problems, especially if the loan is from a finance company or similar business.

Is Debt Consolidation Right for You?

Consider the following questions when deciding whether loan consolidation is in your best interest.

  • Can you afford the consolidation loan? Even if the consolidation loan reduces what you have to pay each month, if you don't have a steady income or can't afford the new monthly payment on the loan, consolidating probably won't help your finances.
  • Can you get a lower interest rate? If you can't get a lower interest rate with a consolidation loan, then it's probably not worth the extra cost and fees you'll incur consolidating.
  • How long will it take to pay off the consolidation loan? If you extend the repayment term when consolidating your debt, you'll most likely pay more interest over the life of the loan.

Others Ways to Manage Your Debt

You probably have other options—perhaps better ones—for getting out of debt trouble rather than consolidating, including:

  • making a budget that permits you to keep up on your debt obligations
  • contacting your creditors to arrange a solution, like a reduced interest rate, a lower minimum payment, or the removal of late penalties or other fees
  • settling your debts for less than you owe on your own or with the help of a legitimate credit counseling agency or lawyer (avoid debt settlement companies, though), or
  • entering into a legitimate debt management plan, or
  • declaring bankruptcy.

Getting Help

If you need advice about how to best manage your debts, consider talking to a nonprofit credit counseling agency. Credit counseling agencies offer financial assistance (including debt management plans and debt consolidation advice), credit counseling, budgeting guidance, and debt management advice for free or at a minimal charge. But be sure you're dealing with a reputable, nonprofit agency—not a for-profit scammer. To find a legitimate credit counseling agency, consider using a member of the National Foundation for Credit Counseling (NFCC).

You might also consider talking to a lawyer to learn about different options for dealing with your debt, including debt settlement and debt consolidation.

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