Debt consolidation loans come in several different varieties, each with its pros and cons. People in debt should make sure they understand all their options before deciding to move forward with debt consolidation.
The four major types of debt consolidation loans are home equity loans, balance transfer credit cards, standard personal loans, and specialized loans designed specifically for debt consolidation.
Home equity loans
Home equity loans enable homeowners to take out new loans by using the equity in their homes as collateral. Equity is the difference between a home’s value and the amount the homeowner still owes on the mortgage. In essence, the homeowner takes out a second mortgage on the home in order to turn that equity into cash.
Home equity loans can be useful to homeowners for a wide variety of reasons. In the case of debt consolidation, the homeowner uses the home equity loan to pay off all his or her other debts at once and then focuses on paying back the loan.
Pros of home equity loans
Home equity loans generally have much lower interest rates than unsecured debts such as credit card debt. By consolidating several different credit card debts into a single, low-interest home equity loan, the homeowner can significantly lower monthly payments and long-term costs.
In addition, interest paid on home loans may be tax-deductible, while interest on credit card debts almost never is.
Cons of home equity loans
When a homeowner consolidates credit card debt into a home equity loan, he or she is turning unsecured debts into secured debts, with a home as collateral. In other words, the homeowner is putting the house on the line in order to consolidate debts. If the individual fails to keep up with the payments, the home is at risk.
Home equity loans can also potentially cost a homeowner more money in the end. The interest rates on variable-rate loans can increase over time, vastly increasing the cost of borrowing. Homeowners might also extend the time spent in debt without realizing it by taking out a new loan. While monthly payments may be lower, it could cost more in the end.
Balance transfer credit cards
Balance transfer credit cards allow cardholders to transfer their balances to a single card. Generally, these cards have low-interest rates (or do not accrue interest at all) for a year or more. During this promotional period, debtors can aggressively pay down their consolidated debt without having to worry about chipping away at newly compounded interest.
Pros of balance transfer credit cards
Balance transfer credit cards can be simple to obtain and simple to understand. A new cardholder might gain approval over the phone or Internet in a matter of minutes and start paying down debt aggressively almost immediately.
By slowing (or pausing) the accrual of interest, balance transfer credit cards also make it much easier to make significant progress toward paying down credit card debt. Every dollar paid on the card goes toward to the principal balance, not just staving off interest, making each payment much more effective.
Cons of balance transfer credit cards
For cardholders with significant amounts of debt, it can be difficult to find a balance transfer card with a large enough credit limit to accommodate all of their debt. If the cardholder’s credit score is less-than-stellar, approval for a new card with a large balance becomes even harder.
Even if the cardholder gains approval, opening up a new credit card and then immediately running up the balance can often cause a person’s credit score to decline. While this sacrifice might be worth it in the end, it’s important to keep it in mind.
If the cardholder isn’t careful, the balance transfer may end up costing more than anticipated. Balance transfers sometimes come with transfer fees, but more than that, the new card may switch to a high-interest rate once the promotional period is over, leaving the cardholder in worse shape than before.
Personal loans are perhaps the most straightforward form of debt consolidation. A borrower approaches a bank or credit union and applies for a personal loan that’s large enough to pay off all of his or her debts at once. After paying off the debts, the individual focuses on paying down the loan itself.
Pros of personal loans for debt consolidation
Much like home equity loans, personal loans generally have much lower interest rates than other unsecured debts such as credit card debt. Lower rates lead to lower monthly payments and allow borrowers to pay off their debts in full much more quickly than they would be able to otherwise.
Cons of personal loans for debt consolidation
It may be very difficult for a debtor with bad credit to gain approval for a personal loan. The lender will examine the debtor’s history with repayment and credit and assume it isn’t worth it to accept the application.
Even if a debtor with bad credit gets the personal loan, it might not be especially helpful. The lender may try to hedge its bets by offering the loan at a higher interest rate, which in turn might lead to marginal-at-best savings over the original debt.
Debt consolidation loans
Banks, credit unions, and other lenders often offer loans that are especially for debt consolidation. These are generally unsecured loans with lower interest rates that compare favorably to credit card interest rates.
Pros of debt consolidation loans
Debt consolidation loans are custom-designed to help debtors deal with their debts. In the best-case scenarios, they come with low-interest rates and manageable monthly payments that provide a clear path to help individuals get out of debt.
Cons of debt consolidation loans
The same drawbacks as personal loans apply here. While there are lenders out there that specialize in providing debt consolidation loans to individuals with bad credit, those loans often come with higher interest rates, longer repayment periods, and less-than-favorable terms. Borrowers should be certain that they aren’t signing up to pay more on their debt than they have to.
How to choose a debt consolidation loan
While each type of debt consolidation loan has its pros and cons, each has its place.
Home equity loans provide some of the lowest interest rates attainable and can be great options for homeowners looking to get out of debt for as little money as possible. Those homeowners should be certain that they’d be able to keep up with the payments, though, since they’re putting their house on the line.
Balance transfer credit cards make sense for smaller amounts of debt held on high-interest credit cards. In the best-case scenario, a cardholder can use the balance transfer card to halt the accrual of interest and pay down the entire principal before the promotional period ends. If the individual can’t pay off the debt before the promotional period ends, however, exceptionally high-interest rates could kick in.
Personal loans and debt consolidation loans can be simple, straightforward ways for debtors to consolidate their debts into low-interest loans that are much easier to pay off. Borrowers with bad credit should be careful, though, as they might end up with high-interest, long-term loans that do them more harm than good.