If you're thinking about ways to better manage your finances, like filing for bankruptcy or settling 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. Theoretically, making one payment to one creditor monthly will be easier to manage than paying several 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.
Debt consolidation has additional advantages and disadvantages, discussed in more detail below.
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."
When you take out a secured loan, such as a mortgage or a car loan, you pledge specific property, such as your home or 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. Various financing firms will also loan you money against lawsuit claims, lottery winnings, and annuities.
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.
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 pros and cons of getting a secured loan to consolidate your debts.
Often, secured loans have lower interest rates than unsecured loans and credit cards, so you might save money on interest payments by consolidating through a secured loan. 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.
But consolidating your unsecured loans into one secured loan presents a couple of huge downsides:
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 cost you more money; another option might be more appropriate for your situation.
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, lowering your interest burden and payment.
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 loan term might be longer than the term of the debt obligations you consolidated. So, you might pay 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.
In addition, 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.
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.
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.
Consider the following questions when deciding whether loan consolidation is in your best interest.
You probably have other options—perhaps better ones—for getting out of debt trouble rather than consolidating, including:
If you need advice on managing your debts best, consider talking to a nonprofit credit counseling agency. Credit counseling agencies offer financial assistance (including debt management plans and 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.