Debt Consolidation: Pros and Cons
Whether you are teetering on the edge of bankruptcy or just trying to better manage your finances, you can t help but notice all the advertisements touting debt consolidation. But is debt consolidation a good option for you?
Read on to learn about the different debt consolidation options and the pros and cons of each.
(To learn about other ways to handle debt, see our Debt Management topic area.)
What Is Debt Consolidation?
With debt consolidation, you get a single loan to pay off all of your smaller loans, thereby leaving you with just one monthly payment rather than several. The theory is that one payment will be easier to manage. The goal is to lower the interest rate and the monthly payment while paying off your debt more quickly.
Debt consolidation is not the same as debt settlement. In debt consolidation, you pay your debt in full with no negative consequences to your credit.
Secured vs. Unsecured Loans
When you take out a secured loan, such as a mortgage or a car loan, you pledge certain property, such as your home or your car, to secure the repayment of the loan. For example, when you obtain a mortgage loan, your house is security for repayment. If you fall behind, the mortgage holder can foreclose on your house to satisfy the loan.
Unsecured loans are based only on your promise to pay and are not secured by any property that can be foreclosed or repossessed to pay the loan. Credit cards are examples of unsecured loans. Unsecured loans usually have a higher interest rate because they carry more risk for the lender.
Debt Consolidation Through Secured Loans
There are many options for debt consolidation using secured loans. You can refinance your house, take out a second mortgage, or get a home equity line of credit. You can take out a car loan, using your automobile as collateral. 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 may 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.
Any of these could be used for debt consolidation. But are they the right option for you?
Pros of Consolidating With a Secured Loan
Often, secured loans carry lower interest rates than unsecured loans so they may save your money on interest payments. Lower interest rates will likely make the monthly payment lower and more affordable. Sometimes, the interest payments are even tax deductible. For example, in many instances interest paid on loans secured by real estate is allowed as a tax deduction.
A single monthly payment with a lower interest rate is likely to ease your financial burden substantially. Also, secured loans are generally easier to obtain because they carry less risk for the lender.
Cons of Consolidating With a Secured Loan
there is a huge downside to consolidating unsecured loans into one secured loan: When you pledge assets as collateral, you are 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 may not be available to you if the loan is not paid back before you need to use them.
The term of a secured loan may also be longer than the term of the debt obligations that you consolidated. This could cause the total interest that you pay over the life of the consolidation loan to be greater than the interest would have been on the individual debts, even though the monthly payment is lower.
Debt Consolidation Through Unsecured Loans
While unsecured personal debt consolidation loans used to be quite common, they are less likely to be available to people who need them today. Generally, an unsecured loan will require the borrower to have very good credit. Accepting a no interest, or low interest, introductory rate on a credit card is often used as a substitute for an unsecured personal loan for debt consolidation.
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 may be higher than a secured loan, it may be less than is charged on several different credit card balances, thereby lowering your interest burden and your payment.
Cons of Consolidating With an Unsecured Loan
An unsecured debt consolidation loan may be hard to get if you don t have sterling credit. Most people who need debt consolidation loans may not qualify. Also, interest rates are generally higher than secured loans. This may result in a payment that is not low enough to make a difference in your financial situation.
Using balance transfer options on no-interest or low-interest credit card offers are tricky. Often, there is a transfer fee in the fine print which negates some of the savings. There are also rules which may diminish the benefits. If you use the card for anything else, the other charges may 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 may provide you with a great deal of emotional and financial relief, it may also leave you feeling prematurely confident about your financial situation. This could cause you to let your guard down and incur additional debt before you have paid off the consolidation loan, starting the cycle all over again.