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Debt consolidation is one of the many common options that people turn to in order to address high levels of debt. Americans who are saddled with heavy debt and struggling with high-interest rates and large monthly payments often turn to debt consolidation to start paying down their debts. For people who have the ability to continue making payments on their debts, and the credit to apply for one, a debt consolidation loan can be an effective option to get you on the path to becoming debt free.
With debt consolidation, all of a borrower’s debts are combined into a new, single loan. That new loan is the primary mechanism that borrowers then use to deal with their credit cards and other debts. A good debt consolidation loan helps borrowers set the conditions that allow them to take control of their financial situation. Once all of a borrower’s debt is consolidated into the new loan, he or she will be left with one single payment to manage each month, instead of multiple payments on different credit cards. This arrangement makes it easier to manage all of their debt and makes it less likely that they’ll forget to make a payment on time.
Ideally, the debt consolidation loan will be at a lower interest than the borrower was paying previously. The lower interest rate will reduce the size of the debt payment that a borrower has to make each month and help decrease the strain that debt is putting on his or her monthly budget. Additionally, the lower interest rate will also reduce the amount of interest being charged on the loan’s principal. This helps to reduce the amount of interest expenses a borrower is racking up each month, and further accelerates the borrower’s capacity to repay all debts.
There are several different types of loans that borrowers can use to consolidate all their outstanding debts and begin the hard work of paying them down. Each debt consolidation loan has its own advantages as well as drawbacks, depending on the terms of the loan and the borrower’s personal financial situation. Additionally, in many cases, a borrower’s credit or lack of collateral will limit the types of debt consolidation that he or she may be eligible for. Let’s look at the interest rate and repayment options for debt consolidation loans, as well as how they should figure into a borrower’s debt repayment calculus. Then, we’ll review six of the most common types of loans that can be used for debt consolidation, and the important things that borrowers should know about each of them.
Rates and Repayment Options
When thinking about the numerous options available for consolidating debts, two critical matters that all borrowers should take into consideration are the potential loan’s interest rate and the time horizon, or the number of payments it’ll take to pay the loan off. While you may be able to qualify for more than one type of debt consolidation loan, you should definitely consider how these two factors could potentially affect your long-term financial situation. In some cases, failing to take the time horizon or the rate of interest you’ll incur on a debt consolidation loan into account could potentially make your debt situation worse.
Prior to shopping around for a debt consolidation loan, borrowers should first calculate the overall rate of interest they’re currently paying on their outstanding debts. If you have multiple credit cards and loans, you can compute a weighted average rate of interest to determine how much you’re being charged each month for your outstanding debt balances. Determining this number is extremely important; when you begin to consider different debt consolidation loan options, you’ll want to choose a loan that charges a lower level of interest than you’re currently paying. The lower interest rate on the new loan will help decrease your monthly loan payment, and also reduce the amount of interest expenses you’re incurring each month. It doesn’t make much sense to consolidate your debts into a loan that carries a higher rate of interest than you’re already paying.
Borrowers should also pay attention to the terms and conditions of the debt consolidation loans they’re considering. Many debt consolidation loans will have fixed rates of interest; the interest rate won’t change over the life of the loan. However, several lenders will offer debt consolidation loans options that have variable rates. The interest rate on a variable rate loan can and usually will change over the life of the loan. Many lenders offer low introductory rates that can be extremely favorable to borrowers, only to increase the rates considerably later on. The balance transfer credit card (which will be discussed later on in this article) is a prime example of a variable rate loan. These cards often offer 0% APR for an introductory rate period of 6-18 months, and then raise interest rates after that introductory period ends.
When considering interest rate options, borrowers seeking to consolidate their debts should also consider the time period in which they need to repay that debt. Some debt consolidation loans are issued for short periods of time. Other debt consolidation options, much like home or automobile loans, are structured to pay back over a period of several years or more. The loan’s debt repayment period is a critical factor when evaluating the different debt consolidation loan options that are out there.
Borrowers with a limited capacity to pay down high levels of debt may need an extended repayment period, with years of low monthly payments. Other borrowers may want to address their debt more rapidly, so they’re not saddled with a loan that could impact their ability to make larger purchases in the future, such as a home or a car. There are debt consolidation loans that are good fits for each of these situations.
Borrowers who need time to pay off high levels of debts may want to consider secured loans, such as the Home Equity Line of Credit (HELOC) option discussed later on. Conversely, borrowers who plan to make a major purchase soon or otherwise want to pay off their debts rapidly may want to consider a variable rate loan with a low introductory interest rate. In any case, considering a loan’s interest rate and the repayment period structure can help a borrower make a more informed decision when it comes time to shop around for a debt consolidation loan.
1. Secured Loans
One option that many borrowers choose to consolidate their outstanding debt is a secured loan. When lenders issue a secured loan, a borrower must use a valuable asset, such as a home or automobile, as collateral to secure the loan. The most common example of these types of loans is the home equity line of credit, or HELOC, which uses the borrower’s house to secure the loan. Personal vehicles are also used to secure debt consolidation loans. However, in most cases, the equity borrowers have in their vehicles won’t be enough to secure a loan large enough to consolidate all their outstanding debt. Finally, other high dollar personal items, such as jewelry, precious metals, and other valuables, can be used to secure a debt consolidation loan, although this method isn’t practiced as widely as using a HELOC.
There are many advantages to using a secured loan to consolidate your outstanding debt. Most lenders view a secured loan as less of a risk than other types of debt, and they’ll offer lower interest rates to borrowers who use them. These loans are often structured with longer repayment periods than other debt consolidation options as well. These two factors will help keep interest expenses in check, and lead to a much lower monthly payment than with other debt consolidation loan types. A lower monthly payment is a more manageable payment! Borrowers that choose to use a HELOC, or otherwise use their home to secure their loan, may also be eligible to deduct the loan’s interest from their Federal income taxes.
There are several drawbacks to secured debt consolidation loans, however. In order to be eligible for loans such as a HELOC, borrowers will need a home or some other valuable asset to secure the loan. Borrowers who don’t own their own home, who have little or no equity in their vehicles, and who don’t have any other valuable real property won’t be able to obtain one of these loans.
Borrowers who obtain a secured loan and run into trouble later on making payments are at considerable risk of the lender foreclosing on their property; that is, if you don’t make your loan payments, you could lose your home or car. Finally, the long repayment periods that are a common feature of these loans can put some borrowers at a disadvantage as well. While you may enjoy lower monthly payments with a secured loan, you’ll spend a much longer period repaying your debts. This can limit your available credit for a long time and make it difficult to make important life purchases later on, such as buying a new home or car.
Borrowers should consider a secured debt consolidation loan if they have a very high level of debt and their monthly payments are making it increasingly difficult to keep up with all their other monthly expenses. They should be confident enough with their financial situation, and their ability to continue paying the new loan, to use their home or car as collateral. If so, the low interest that’s typical with these sorts of loans can help bring a borrower’s monthly debt repayments under control. While the repayment horizon may be longer, that low interest rate will ensure that your monthly payments remain manageable over the long haul.
Conversely, borrowers with no real property, or who are concerned about making payments consistently each month, should consider other options to deal with their debts. One missed payment could put an important asset in jeopardy. Additionally, borrowers who expect to need their credit to make a major purchase in the future should consider debt consolidation loan options with shorter payment horizons. The long-term structure of most secured debt consolidation loans can make it difficult to obtain additional credit when you need it the most.
2. Unsecured Loans
A second debt consolidation option is the unsecured loan. An unsecured loan is exactly what it sounds like: a loan that lacks any collateral on the borrower’s behalf and is not secure. Unsecured debt consolidation loans are similar to the loans borrowers might take out from a bank for activities such as home improvement or opening a business. However, due to the increased use of this method to address outstanding debt, more and more lenders are offering unsecured loans specifically for the purpose of debt consolidation. Borrowers obtain these loans from traditional banks, savings and loans, or credit unions, and increasingly from nontraditional lenders that operate online.
There are many benefits for borrowers who choose an unsecured loan to consolidate all their credit card and other debts. For starters, you don’t need any real property to use as collateral to obtain one of these loans. Additionally, there are scores of lenders currently offering unsecured debt consolidation loans. This makes it extremely convenient for borrowers to search for and find an unsecured loan option that’s a great fit for their particular financial situation. Finally, unlike a secured loan, a borrower’s assets are not at risk if he or she runs into problems making the monthly payments later on.
However, there are several things for borrowers to consider prior to choosing an unsecured debt consolidation loan. Since there’s no collateral to back these loans up, lenders consider unsecured debt consolidation loans riskier than options such as a HELOC; as a result, they often charge higher interest rates. Depending on the interest rates a borrower is already paying on credit card and other debt, an unsecured debt consolidation loan may not offer much of a respite when it comes to monthly debt repayment. Lenders will also be wary of offering an unsecured debt consolidation loan to borrowers with less-than-stellar credit. Many borrowers who are considering debt consolidation, unfortunately, don’t have the credit score to get an unsecured loan with an effective interest rate; in many cases, borrowers may lack the credit to obtain any unsecured loan at all.
Unsecured debt consolidation loans are good choices for borrowers who have average or good credit and either lack the collateral to secure a loan or don’t want to risk using an important asset as they consolidate their debts. These loans are particularly good options for borrowers who are faced with extremely high-interest rates on their current debts and having trouble paying off all that debt’s principal. Finally, an unsecured loan is a good option for a borrower who wants to pay off an outstanding debt quicker than a secured loan typically allows.
Borrowers who have below average or bad credit will have difficulty obtaining an unsecured debt consolidation loan, or at the bare minimum, won’t be able to obtain one of these loans with an interest rate that works in their favor. Prior to signing on to an unsecured debt consolidation loan, borrowers should compare their current interest rate and combined monthly debt payments to what they’d pay if they choose a particular debt consolidation loan option. If the interest rate on the unsecured loan won’t do much to reduce monthly payments or affect the rate that you’re accumulating interest on the loan’s principal, an unsecured loan isn’t a good option for your situation.
3. Credit Card Balance Transfers
Another popular debt consolidation option is the credit card balance transfer. With a balance transfer, borrowers with high balances on multiple credit card accounts consolidate them to a new card. Many lenders offer credit cards specifically for balance transfers. Many of these companies offer 0% APR introductory rates on these cards for anywhere from six to 18 months. Borrowers who transfer their old credit card balances can then address their debts without racking up additional interest expenses, as long as they pay off their balance prior to the end of that introductory period.
Credit card balance transfers are good options for borrowers whose high debt levels are due to balances on multiple credit cards with high-interest rates. Transferring all your debt to a card with no initial interest will help you address the balance without incurring additional debt. This is a great choice for a borrower who has the willingness and capacity to pay off their outstanding debts during the card’s low-interest introductory period.
The major drawback to credit card balance transfers is the risk of carrying a debt balance past the introductory rate period. Many of these cards tend to increase rates significantly once that introductory period closes out. Borrowers who are unable to pay off the debt balance before that period ends may suddenly start incurring significant interest expenses each month, which could make their debt even more difficult to pay off than it was before the balance transfer.
Borrowers will also have to examine the total amount of debt they’re carrying and their debt mix when considering a credit card balance transfer. If you have an extremely high level of varied debt, such as credit cards, store credit, auto, and personal loans, it may be difficult to transfer all of that debt to a single credit card. Additionally, it can be difficult for many borrowers to pay a high level of debt off within a credit card’s introductory rate period. If you expect to need a longer period to address your outstanding debts, you’ll likely need to consider an alternative to a credit card balance transfer.
4. Peer-to-Peer (P2P) Debt Consolidation
Another option for borrowers attempting to deal with high levels of outstanding debt is to consolidate that debt with a peer-to-peer (P2P) loan. P2P debt consolidation is a relatively new form of lending; it’s only been available as a widespread option for a decade or so. However, the P2P market is buoyed by increasingly powerful tech applications that are making it more effective for borrowers and investors alike, and P2P platforms are rapidly becoming a trusted and accepted part of the financial world.
When considering a P2P debt consolidation loan, borrowers can choose one of many online platforms, such as Upstart or Funding Circle, to apply for a loan. Individual investors who are affiliated with the P2P platform in question can look at the borrower’s profile and loan request and decide whether to offer a direct personal loan and if so, with what terms. Many of these platforms charge borrowers and investors small fees for using their services or otherwise charge investors a small percentage fee on the profits they make when they execute successful transactions on the platform.
P2P lending, as one of the newest debt consolidation options, offers many unique advantages over more traditional lenders. Since people seeking loans are dealing with investors and not lenders, borrowers with less-than-perfect credit may be able to obtain a debt consolidation loan from an investor on a P2P platform when banks and other lenders would simply pass. Borrowers can often search more rapidly for a lender on one of these platforms than they could on their own as well.
Many P2P platforms use the latest artificial intelligence and machine learning technology available too, so they’re exceptionally adept at matching lenders to available (and willing) investors. Prospective borrowers are able to apply for debt consolidation loans rapidly on these sites and can usually see what loans are available for in a matter of minutes. Additionally, depending on the P2P platform you choose, you may not have to execute a hard credit check when applying for a loan, either. Once a borrower is approved, most P2P sites operate like any other lender, making the loaned amount available in quick fashion.
P2P debt consolidation may not be the best option for every borrower, however. There are several states, such as Iowa, Maine, and North Dakota, where state law limits the scale and scope of peer-to-peer lenders. Borrowers should definitely determine how the laws where they live could potentially affect their ability to use P2P lending services. In some cases, it may not even be a legal option to consider. Borrowers who are less comfortable with technology or impersonal financial transactions may want to look at other debt consolidation options.
Additionally, borrowers may find the same types of challenges with P2P debt consolidation that they’d encounter with traditional lenders. Borrowers with poor credit ratings may not be able to obtain an interest rate on a P2P loan that makes their debt situation any more manageable than what they already have; in some cases, investors on these platforms may judge a borrower as too high a risk to provide a loan at any interest rate. Finally, the fees these platforms charge for their services may make P2P untenable for many borrowers.
5. 401(k) Debt Consolidation
Do you have a 401(k) retirement account? If so, another option that you may have for debt consolidation is a 401(k) loan. Some 401(k) plans allow account holders to borrow up to $50,000 against their accounts to consolidate credit card and other debts. Borrowers then “pay back” the debt consolidation loan into their retirement accounts.
Interest on these loans is usually low–often a point or so above the prime rate–and all the interest paid goes back into the borrower’s 401(k) account. Additionally, since you’re borrowing from your own account, there’s no significant impact on your credit score when using a 401(k) loan. These characteristics make 401(k) loans an extremely popular option; it’s estimated that about one in five people who possess a 401(k) retirement account are currently borrowing from it.
There are serious drawbacks to using a 401(k) loan, however. Borrowers who use a 401(k) loan for debt consolidation may incur significant tax or other early withdrawal penalties for doing so. Additionally, withdrawing funds from your retirement plan can impact the rate of return on your savings and limit the amount of funds you accumulate. This could leave you insufficiently prepared for retirement when the time comes.
There may be further obstacles that close off this option to borrowers with high levels of debt. If you haven’t yet accumulated a substantial sum of money in your 401(k) account, it may not make sense to withdraw any money from it as a loan. Your 401(k) administrator may not permit account holders to withdraw funds for certain types of loans, either. Finally, if you have a different type of retirement savings account, or have failed to start saving for retirement, this may not even be a consideration as you attempt to consolidate your debts.
6. Friends and Family
Another option borrowers can consider to consolidate their debts is to head for home and obtain a loan from their family or close friends. A cash loan from a family member or close friend–at a low or no interest rate–can be an effective means to consolidate outstanding debts. If asking people you’re close to for a loan seems unusual, think again; about 35% of people have indicated they’ve loaned money to a family member at one point or another. People have been able to achieve great success thanks to a little financial help from their families. Jeff Bezos started Amazon with the help of a loan from his parents, after all!
Borrowers who consolidate debts with a loan from a family member can often obtain extremely favorable terms; in some cases, the family member may not charge any interest on the loan at all, or otherwise, offer extremely favorable repayment options. A family loan won’t usually require a credit check, and it won’t impact the borrower’s credit rating in most situations, either. Finally, for borrowers with high levels of debt or poor credit, a loan from a family member or close friend may be the only option available to consolidate their debt.
However, there are considerable risks involved with accepting a loan from a friend or family member. Any issues you may encounter with paying back the loan could potentially have a lifelong impact on important relationships with the people you care the most about. Your inability to pay back the loan you took could potentially add significant financial pressure on your family member later on, too. Finally, confusion about the terms of repayment can cause significant tension in close-knit families.
If you’re going to ask a family member for a loan to consolidate your debts, you should definitely take the aforementioned risks into consideration before doing so. If you believe there’s a chance you could default on the loan, or otherwise have grave concerns at putting your relationships at risk, you should definitely consider different debt consolidation options. If you do decide to go ahead with a family loan, you should try to capture all the loan’s terms in a written and signed document, so there’s absolutely no confusion between any involved party. Your relative and you should also get advice from a good accountant as well, since there may some tax implications for this type of loan too.
Many Options, So Get Some Help
Debt consolidation can have a significant impact on your financial situation. Borrowers can often turn a debt consolidation loan into the key component of a successful plan to become debt free. However, if you make the wrong choice with debt consolidation, you can end up in worse financial shape than when you started. So, don’t just jump in and select the debt consolidation loan that’s the easiest to obtain; take the time to evaluate your personal situation and choose the best option for you.
When dealing with a high level of debt, you should never go it alone, either. Find a trusted advisor to help you analyze your situation and evaluate the various debt consolidation options that are available to you. In some cases, a good financial advisor may help you determine that there’s no good debt consolidation plan for you at all, and can assist you in looking at other options to deal with your outstanding debt.
Whatever you plan to do to address all those credit cards, start today! Every moment you delay addressing your debts, you rack up interest expenses and make it that much harder to pay back everything you owe. So, get moving right now and start figuring out how you can build a debt-free future.
