How to Consolidate Debt: Choosing the Right Loan

You want to get your bills under control, and have heard about debt consolidation as a solution. But you don't know how to consolidate debt. What sort of loan should you choose? Secured or unsecured? Knowing the difference can help you choose the right debt consolidation financing.

How Secured Loans Work

As the name implies, this is borrowing that's "secured" by collateral. Collateral is an asset the borrower allows the lender to take if the loan is not repaid as agreed. Mortgages, including home equity loans and lines of credit (HELOCs), are secured by houses. Auto loans are generally secured by vehicles, and other valuables can be used as security, including jewelry, artwork and even retirement funds (for 401k loans). Lenders love this type of loan because it reduces their risk of losing money on the deal.

If you default on your payments, the lender can take the property and sell it. Any remaining proceeds from the sale after the loan is repaid are returned to you.

How Unsecured Loans Work

Unsecured loans require no collateral. They include most personal bank loans (signature loans), credit cards and unsecured lines of credit. These loans are also called "character loans" because the lender has to rely on your willingness to repay the debt. That's why your credit score and report are so important for an unsecured loan application.

Of course, just because there's no one asset directly at stake doesn't mean your assets are safe if you fail to repay an unsecured loan. Lenders and collection agencies can hound you into court or bankruptcy if you default.

Advantages of Secured Loans

In an ideal world, you should have three goals when you consolidate debt:

  1. A lower interest rate
  2. Less interest over the life of the loan
  3. An affordable payment

Using just those criteria, a secured loan is likely to win hands down for homeowners. Because secured loans are less risky to lenders, their interest rates are lower.

Downsides of Secured Loans

The math that makes secured loans look so attractive doesn't consider the greater likelihood of losing your assets if you fall behind with payments. If your loan is a cash-out mortgage refinance, home equity loan or HELOC, the collateral that you're risking is your house.

So, for those whose financial lives are challenging, it may be worth paying a bit more to put extra distance between you and homelessness or a blank spot on your wall.

If you have to file for bankruptcy protection, unsecured balances can probably be discharged. However, once that debt is replaced by a secured loan, it can't be discharged unless you give back the collateral.

There are other factors here:

  1. Zeroing credit card balances with home equity loans can drop interest rates and payments dramatically. However, if you repay your debt over 15 or 30 years, you'll probably end up paying more interest.
  2. It usually takes longer to get your hands on funds from secured borrowing because the process is more complicated.
  3. There are generally higher upfront fees, including appraisals and closing costs.

Advantages of Unsecured Loans

Unsecured loans can usually be processed and funded quickly because there is no collateral to appraise and insure. You can have your money within days or sometimes even hours. Fees are generally lower than those of secured financing because there is less work to do and less paperwork to manage. For debt consolidation, unsecured loans can force you to be disciplined about repayment because their terms are shorter than mortgages -- normally one to five years.

Downsides of Unsecured Loans

The downsides of unsecured loans are:

  1. They are almost always more expensive because they have higher rates.
  2. Um...
  3. That's it.

Making Up Your Mind

That's a lot of information. So how do you decide how to consolidate debt? You have to take into account all your personal circumstances.

There are several downsides to secured loans. But, for many, their three upsides (affordability, affordability and affordability) outweigh them all. Luckily, few of us live with a constant fear of foreclosure. It's a real possibility, but it sits in the back of our minds, next to our dread of being struck by a meteor or lightning.

And, yes, we know that it usually costs more to pay down a low-interest debt over 30 years than a high-interest one over three. However, that can be managed by taking out a low-interest loan and accelerating it with a higher payment. You still get a monthly reduction, but you don't stretch out the repayment and you pay much less interest. For example:

debt cons with heloc

Of course, many have no choice but to explore unsecured loans. Their number includes those who don't own their own Rembrandts or homes. And it includes homeowners who are risk-averse or whose mortgages are underwater, along with 401(k) holders who aren't prepared to gamble with their futures.

Into which group do you fall? By all means, online comparison shop until you drop because there's a wide range of deals out there. But the decision you make will be determined by the sort of person you are, and the particular circumstances in which you find yourself.

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