Many view Debt Consolidation as robbing Peter to pay Paul. However, in some situations it may prove to be the right financial instrument to get you out of a bind.
What is Debt Consolidation?
With debt consolidation, you get a single loan to pay off all of your smaller loans or credit cards, thereby leaving you with just one monthly payment rather than multiple. The rationale with consolidating is that one payment will be easier to manage. Moreover, by combining your unsecured loans and credit cards you should theoretically be able to lower the overall interest rate on the total debt amount. The ultimate goal of a debt consolidation loan is to lower your interest payments (APR), have one convenient monthly payment and pay more towards principal so you can pay off your debt quicker.
Many people become confused when they heart the term "Debt Consolidation" and for good reason. The term is used interchangeably with many debt relief options and it shouldn't be. A traditional debt consolidation loan is quite different from a debt settlement, debt negotiation or a debt resolution program. Although, all of these options are technically a debt consolidation, with a debt consolidation loan you are paying your debt back in full (plus interest) and typically having no negative consequence to your credit. The Debt Relief Company Program (The DRC Program) on the other hand, allows you to resolve your unsecured debts for less than what you owe. Although, the savings in principal and interest does require some give and take from the consumer (must close credit card accounts, etc.).
Secured vs. Unsecured Loans
When you take out a secured loan, such as a mortgage or a car loan, you pledge certain property (otherwise known as collateral), such as your home or car to secure the repayment of the loan. So if you were to ever default on the collateralized loan, the bank that issued the loan has some "security" or "collateral" which they can legally take ownership of. In a way, it a safeguard, so that if worst came to worst, the bank or lender would not be completely out of the money they lent. For example, when you obtain a mortgage, your house is the security or collateral backing your repayment. If you were to default, the mortgage holder could foreclose on your house to satisfy the terms of the loan. However, since you live in the home, this is viewed as unlikely and less risky (from the lender's perspective at least). So banks and lenders tend to view these loans and less risky.
Unsecured loans, on the other hand, are based only on your promise to pay and not secured by any property that can be foreclosed or repossessed to pay the loan back, were you to default on the debt. Medical debt, personal loans, credit cards, and revolving lines of credits are all examples of unsecured loans. Because unsecured loans are not backed by collateral and carry more risk for any given lender, they usually have a higher interest rate.
Debt Consolidation Through Secured Loans
There are many options for debt consolidation using secured loans. You can refinance your home, take out a second mortgage or even get a home equity line of credit (credit allowing). You can also use your automobile or any other qualifying asset as collateral to back the issuance of the loan. Other assets that can be used for collateral include a 401K retirement fund, life insurance policy (with a cash value), lawsuit claims, lottery winnings and even annuities. Although these are all possible options, a lot of times they might not align with your individual goals in achieving financial freedom and can actually do more harm than good in the long run.
Pros of Consolidating With a Secured Loan
Often times, secured loans carry much lower interest rates than unsecured loans. Because they are considered less risky they may save you a lot of money on interest in the long run. Lower interest rates will likely reduce your monthly payment and increase your cashflow. Additionally, the interest payments made on secured loans are often tax deductible. The most common example of this is the mortgage tax deduction. For this reason, many Americans chose to opt for an itemized deduction (especially if the interest paid on their mortgage exceeds that of a standard deduction). Moreover, a single monthly payment with a lower interest rate is likely to ease your financial burden. Secured loans are also generally more easy to obtain since they are collateralized and carry less risk for the lender.
Cons of Consolidating With a Secured Loan
There can be many downsides associated with 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 funds, or whatever else you used to secured 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 terms of the secured loan may also be much longer than the terms of the debt obligations you initially consolidated. This could cause the total interest that you pay over the life of the consolidation loan to be greater than the interest you would have otherwise paid on those individual debts. The deception lies in the fact that even though you have a lower payment and lower interest rate, the amortization of the consolidation loan could actually cost you more in the long term due to the effects of compounding interest.
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 actually need them today. Generally, an unsecured loan will required the borrower to have very good credit and a good debt to income ratio. As opposed to an unsecured consolidation loan, many people choose to go the route of balance transferring to a 0% APR introductory rate on credit cards. However, that can lead to a very slippery slope in which the individual gets hit with a lump sum of interest all at once. With both options you are robbing Peter to pay Paul and you should always exercise caution if you plan on using either of these routes.
Pros of Consolidating With an Unsecured Loan
The biggest benefit of an unsecured debt consolidation loan is that it will allow you to acquire funding without the need of backing assets to the debt obligation. Since you have not collateralized any personal property, no property is at risk of being repossessed. While the interest rate may be higher than a secured loan, it may be less than what is typically charged on multiple credit card accounts, thereby lowering your interest burden and your monthly payment.
Cons of Consolidating With an Unsecured Loan
An unsecured debt consolidation loan may be hard to get if you have exceptional credit worthiness. Most people who actually need debt consolidation loans typically do not qualify for them (which is really unfortunate and says a lot about the current state of the US credit & banking system). Interest rates from these types of loans are also generally much higher than collateralized loans. More often than not, the resulting monthly payment is not low enough to make a significant difference in your financial situation.
Using balance transfer options, no-interest or low-interest credit card offers can also be a very slippery slope. In essence, you are robbing Peter to pay Paul and just delaying the inevitable. Additionally, in most cases there is a transfer fee in the fine print which negates most of the savings. There can also be other rules that greatly diminish the benefits. For example, 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 period is generally limited and sometimes under a time constraint. So if you can't pay the debt off during the promotional time period, you may actually end up paying severely high interest rates once the special offer period expires.