Debt Consolidation Loans
Any given loan will be either secured or unsecured:
- Secured loans - are loans in which your asset acts as collateral for the loan. If you default on the loan, the lender can take possession of your asset, sell it, and use the proceedings to cover the loan balance. Interests rates for secured loans are typically lower than those for unsecured loans.
- Unsecured loans - in these type of loans, your asset is not used as collateral. If you default on the loan, the lender will have to initiate collection procedures and can eventually obtain a court order in an attempt to recover the money. The added risk for lenders results in higher interest rates. Approval is primarily based on your credit score (in addition to income and total debt). An unsecured loan may be more difficult to obtain if you don't have a high credit score.
A loan, of any type, should possess certain general qualities to be suited for debt consolidation:
Secured Debt Consolidation Loans
These type of loans can be obtained only if you own some type of valuable property, most commonly a home.
When you consolidate your debt with a secured loan, you are essentially moving your debt from the unsecured category into the secured category. For the lender, this represents a move towards an increased level of security, but for you the borrower, it's the exact opposite: once you transfer your existing debt into a secured loan, your home (or some other major asset) is put at risk. If you fail to make your payments, you can loose it. A house is usually the largest asset you own. That's why it is crucial that you consolidate your debt with a secured loan only if it will be very easy for you to make the monthly payments under the new terms.
Pros of a Secured Loan
- Lower interest rate compared to unsecured loans (in most cases)
Because it is backed by your asset, the lender will usually be able to offer a lower interest rate on a secured loan.
- Interest can be tax deductible
- Option of a fixed rate
- Option of extended repayment period
A longer repayment period, in addition to a low interest rate, will make your monthly payments even more affordable.
- A perfect credit score is not necessary
A less than perfect credit score could be sufficient to qualify for a secured loan, since the lender is guaranteed by your asset acting as collateral in case of default. Still, with an excellent credit score you'll usually be able to get a better rate.
Managing just one account and making a single payment each month (as with all debt consolidation options) will make for easier and less stressful money management.
Cons of a Secured Loan
- Your property is at risk
If you default on the loan, you can loose the asset you have placed as collateral, which in most cases means your home.
The costs will vary with the type of secured loan, but can be higher than those associated with an unsecured loan. For example, with a mortgage refinance loan there will be significant fees and you may also have to pay "points" to secure better rates.
- Low flexibility (in some cases)
There can be no other option than an extended repayment period, which can lead to higher total interest costs. However, in order to compare your "real" interest costs with other loans, you must take into account the current and expected inflation rate and the cash cost of interest as an effect of being able to deduct it from your tax return.
- Incentive to get into debt again
The much lower monthly payment resulting from lower interest and/or extended repayment periods could cause you to start overspending again, eventually adding more debt and increasing your financial problems rather than solving them.
- Can take some time to get the cash
If you need the cash quickly, some types of secured loans could not provide it fast enough.
Secured Debt Consolidation Options:
Home Equity Loan
There are two types of home equity loans:
- Closed end (referred to as "home-equity loan" or "second mortgage").
- Open end (referred to as "home-equity line of credit" or "HELOC" or, just like the closed end, as "second mortgage").
Both are secured against the value of the property, just like a traditional mortgage.
The difference is that the home equity loan (closed end type) is a one time lump-sum loan with typically a fixed interest rate, whereas the HELOC (open end type) is a line of revolving credit with an adjustable interest rate.
Home equity consolidation loan
When you use the cash you receive from a home equity loan to pay off your debt, such as the balances on your credit card accounts, you are in essence using the home equity loan as an instrument of debt consolidation, moving the debt from your high interest credit card accounts to a low and tax deductible interest loan, from an unsecured to a secured loan.
Pros of using a home equity loan to consolidate your debt
- Interest is tax deductible (in contrast, the interest paid on unsecured debt consolidation loans is not tax deductible).
- Low interest rate - because the loan is secured by your home acting as collateral, the lender will usually offer a significantly lower interest rate compared to an unsecured loan. However, a cash out mortgage refinance will typically offer an even lower rate.
- Flexibility - you can choose to repay your loan over 5, 10, 15, 20, 25 or 30 years.
Cash Out Mortgage Refinance
This option can also be used as a form of secured debt consolidation. Whereas with a home equity loan you keep your original mortgage and take out a second loan (referred to as second mortgage), with cash out refinancing you actually replace your first mortgage with a new, larger, mortgage. By refinancing your property for an amount that is greater than the one you owe on your current mortgage, you'll get the extra amount liquidated to you in cash ("cash out") which corresponds to the amount added to the remaining mortgage balance. You can now use that cash to pay off your high-interest accounts.
Pros of a cash out mortgage refinance
- Interest is tax deductible
- Very low interest rate (usually lower than a a home equity loan)
Cons of a cash out mortgage refinance
- High fees - Just like with a normal mortgage, there are significant fees involved with a cash out mortgage refinance. Most of them are unavoidable, and include: lender fees (for underwriting and application), government recording charges, title search, title insurance, appraisal costs, credit report, flood certification, settlement (closing) fees and, in some cases, points (each point corresponding to an up front fee equivalent to 1% of the amount you borrow).
- Long term repayment schedule - you're typically going to be stretching payments out over 15 or 30 years with no option of a shorter length, as this will correspond to the mortgage repayment period. Therefore, the total interest cost can be quite high over the term of the loan. Check the terms to see if there is an early repayment penalty. If there is no penalty, you can always pay the loan back as soon as you have the funds, even if the original period has not expired. In addition, you can pay more than what is required each month.
- The low monthly payment might make you relax too much and start accumulating more debt
It is therefore essential that you use this type of secured consolidation loan as a one-time-only (if ever) option. You must concurrently be sure to solve the underlying problem that got you into debt in order to avoid any other debt burden building up again in the future.
Car Title Loan
If you own a car (or even a boat or a motorcycle) with a free and clear title, you might have considered taking out a title loan to consolidate your debt. Think again: this is a very bad idea.
Similarly to payday loans, title loans are very easy to obtain even when you have bad credit, because they often don't require a credit check. However, the problem is that they come with astronomically high interest rates. Before you know it, you'll find yourself victim of a vicious cycle with your debt growing at uncontrollable levels because of fast compounding interest. You might end up owning multiples of the original amount borrowed with no way out of it.
The only plausible use of a car title loan is therefore for an urgent and unexpected expense which you are not able to cover in any other way when it occurs, and that you'll be able to pay back within a short period of time (possibly in a matter of weeks, typically within 1 month). Title loans should never be considered an option for debt consolidation.
If you have bad credit and a debt problem that can't be solved in any other way, consider a debt consolidation alternative such as credit counseling.
Your 401k (or other type of employer-sponsored retirement account) can allow you to borrow from it (around 50% of plans do, and this percentage increases to 98% at midsize to large companies). In that case, you can borrow part of the amount invested in your account (typically 50% or $50,000, whichever is less) to consolidate your debt. Interest is charged on the loan per IRS regulations, but it is paid back into the 401k and it continues to grow with the rest of your investment. 401(k) loans commonly come with a payback period of 5 years or less.
Pros of a 401k loan
- no credit check is required.
- quick and easy loan application (compared to bank loans). Some plans only require a phone call.
- low interest rate (and you are paying it back to yourself, not to someone else).
Cons of a 401k loan
- if you loose or leave your job during the life of the loan, you may have to repay the loan within 30 to 90 days (usually 60 days), or pay the taxes and penalties associated with early withdrawal.
- you will be essentially taxed twice on the amount you take out, because you'll first have to pay it back with after-tax money and then you'll be taxed on that same amount when you eventually withdraw it from the plan at retirement.
- the interest isn't tax deductible (unlike a home equity loan).
- if you don't pay the money back within the term of the loan (typically 5 years), you will be assessed a 10% penalty, in addition to income taxes, on the balance of the loan.
- opportunity cost of missing out on the investment returns during the life of the loan.
- some companies do not allow contributions during the loan period.
Life Insurance Loan
If you have a life insurance policy, you have the option of taking a life insurance loan (also called "policy loan"). You will receive a cash disbursement out front and interest is going to be charged on the loan. There are complex and potentially dangerous tax implications when taking a policy loan, so be sure to you fully understand them and continue to monitor your policy annually.
Unpaid interest will be added to the loan amount and be subject to compounding (you'll be paying interest on any unpaid interest), so it is advisable to pay your loan interest out of pocket rather than have the dividends pay your interest. Otherwise, you might end up owing to the IRS more than the total amount of the loan you originally took out. That's because the IRS considers the compounded interest as interest income.
In addition to interest, you may be charged an opportunity cost for removing the loan from the market, corresponding to the difference between the return when invested and what it will make in the guaranteed account. Unlike a conventional loan, with a policy loan you have the option of not paying the loan back, and any money you take out will be deducted from the death benefit which goes to your beneficiaries.
Unsecured Debt Consolidation Loans
If you're not a homeowner, don't have a 401k retirement plan, nor a life insurance policy, your options for debt consolidation are restricted to a credit card balance transfer or an unsecured debt consolidation loan.
We've listed elsewhere the places to go for a debt consolidation loan and listed some companies. In this section, we'll review the different types of unsecured loans, the pros and cons of these loans, and whether they are suited for consolidating debt.
What to look for in an unsecured loan
- No annual fees and no application fees - Find a loan without that doesn't charge these fees.
- Low (or zero) origination and early termination fees - Check whether there are penalties for paying down the principal and paying it off sooner than the loan period. The best loans will come with no pre-payment penalty or loan origination fees. You want to be able to prepay all or part of your loan at any time without penalty.
- Reasonable late payment fees and penalty - You'll want to privilege a loan with a low late payment fee and no increase in the interest rate should you make a late payment on your loan.
- Interest rate < rate on current debt - The rate on your unsecured consolidation loan must be lower than your current rate on credit cards and other loans you are looking to consolidate.
Pros of an unsecured loan
- Fast - You can get the loan approved and receive the cash in a short period of time.
- No collateral required - You won't loose property if you default on the loan.
- It may offer a fixed interest rate and a fixed repayment period - so you'll know how much you need to pay each month and for how long (as opposed to credit cards, which have a variable rate and indefinite repayment periods if you only make minimum payments).
- Simple interest - this type of interest is calculated on the outstanding principal only, as opposed to compound interest, which is calculated each period on the original principal and on any accrued and unpaid interest. Credit card debt uses compound interest, whereas personal unsecured loans usually use simple interest. This will result in less interest charged over the life of the loan, although the savings are negligible.
- Convenience of making a single payment each month (as with any consolidation option).
Cons of an unsecured loan
- HIgher interest rate (compared to a secured consolidation loan) - The interest rate on unsecured loans is usually higher than the rate on secured loans (because of the greater risk for the lender).
- More difficult to obtain - Without a very good credit score, you are unlikely to be approved for an unsecured loan with an interest rate which is lower than the aggregate rate on the debt you want to consolidate.
- No tax deduction - Your interest costs incurred with a unsecured debt consolidation loan are not going to be tax deductible.
Unsecured debt consolidation options (and which ones to avoid)
- Personal Loans (Signature Loans)
- Peer to Peer Loans
- Payday Loans (not suitable for consolidation)
- Advance fee loans (scam warning)
Personal Loans (or Signature Loans)
These are a popular way to consolidate debt.
Consolidating with a personal loan (also called with the generic term unsecured loan) from a traditional bank can be advisable if you want to pay off your debt in 5 years or less (although some banks offer repayment period of up to 7 years), you have good credit, and you don't own a home (or don't want to use it as collateral).
Loan amounts can typically range anywhere between $1,000 and $100,000, depending on the lender. When you apply online, you can get a credit decision within 24 hours. The interest rate on a personal loan is usually fixed over the life of the loan.
Peer to Peer Consolidation Loans
most P2P loans (or person to person loans) are unsecured personal loans that are made available from individuals towards other individuals, without going through a traditional bank or financial institution. The intermediation is instead provided by a peer-to-peer lending company.
Peer-to-peer loans can offer better rates to borrowers compared to traditional banks.
All transactions, from application to funding and repayment, take place online. Once you are approved and provided with a rate (based on your credit score), you post your loan request on the platform in order to attract investors willing to lend you the money. Multiple investors typically will co-found different portions of your loan amount.
Although you might sometimes qualify for a peer-to-peer loan when your credit score prevented you from being approved for a traditional bank loan, you still will need a fairly good credit score to be approved for a peer-to-peer loan with a rate that makes consolidating your debt convenient to you.
Payday Loans (not suitable for consolidation)
A Payday Loan (also called a payday advance) should never be used to consolidate debt. Payday loans are short-term high interest unsecured loans that are usually due on your next payday after the loan is disbursed. Your next paycheck acts as guarantee for the loan.
When obtained online, the cash you borrow is transferred by direct deposit to your bank account and the loan repayment, in addition to the finance charge, is electronically withdrawn from your account at the next payday.
The interest rate on payday loans is astronomical (300% - 400%), but these loans are still very appealing for borrowers with an immediate cash need and/or bad credit, because the loan can be approved within a few hours, often requiring no credit check or employment history verification at all. Getting money with a payday loan is therefore fast and easy, but it comes at an extremely high cost.
Payday loans are not a viable option for debt consolidation because their interest rate will always be much higher (10 or 20 times as much) than the one on your credit cards. They are meant for emergency situations only. Some payday lending companies have violated laws by charging borrowers more than the stated cost of their loans, sometimes because the lender would make multiple automatic withdrawals rather than a single one, each time assessing a finance charge.
Advance Fee Loans (Debt Scam Warning)
If a company guarantees you a loan if you pay them a fee in advance, it is most probably a scam.
Legitimate creditors can require an application or appraisal fee in advance, but they cannot at the same time guarantee a loan (or even just represents a high likelihood of your getting it). Under the FTC’s Telemarketing Sales Rule, if a company guarantees that you will get a loan, it can't ask for payment until you get the loan.
What to look for in a debt consolidation loan
The ideal debt consolidation loan is one that offers lower interest rates, lower total interest payments, and lower monthly payments without at the same time turning your debt from unsecured to secured (therefore placing your property at risk). When shopping around for a debt consolidation loan, make sure you read the fine print carefully and review and compare the following items before you sign any agreement:
Interest rate: low and fixedMake sure that the APR (annual percentage rate) is lower than the interest on your current debt and fixed (it must not change over the life of the loan).
Repayment term: shortHow long will it take to pay off the loan? This is typically expressed in months (e.g. 60 months). Divide the number of months by 12 and be aware of how many years it will take to pay off the loan. Make sure that you are comfortable with making payments for that long a period.
Total interest chargesHow much will you be paying on interest rather than toward paying off your debt during the life of your new consolidated loan? Ideally, you will want the total amount of interest charges to be equal or less than the amount you would be spending on interest if you did not consolidate your debts. Interest costs are directly correlated to interest rate and repayment term: the higher these values are, the higher the interest costs will be.
Fees: lowYou should research and compare the fees charged by each offer you are considering. Add together the total fees with the total interest costs to find the least expensive debt consolidation loan, provided that you are comfortable with the new monthly payment amount that will be required from you. Following is a list of possible fees:
- Origination Fees (or "Closing Fees") - Usually expressed as a percentage of your total loan amount. They can amount to a lot.
- Annual Fees - Usually charged with home equity loans and home equity lines of credit (HELOC).
- Balance Transfer Fee - Are charged only with credit card balance transfers, not with traditional loans.
- Late Fees - Will vary depending on the type of loan.
- Early cancellation fees ("Prepayment penalty") - What happens if you pay off the loan early? Early cancellation fees can be applied (for example, these fees are common when taking out a HELOC). Lenders charge these early cancellation fees as a way to make up for the interest revenue they were planning to earn from you but that they will not earn anymore because of you paying off your debt consolidation loan early.