Dealing with debt can be a frustrating, emotionally taxing experience. Whether you carry high credit card balances, persistent medical debt, or a crippling mortgage, your financial obligations can interfere with your ability to live a balanced life. If you feel like you just can’t pay off your debts on your own, you may be considering an option that has provided relief for hundreds of thousands of other Americans: a debt consolidation loan, also known as a refinancing loan.
These loans can be a big help to borrowers who owe significant money – but they do come with risks. It’s important to understand the drawbacks and consider all your alternatives before deciding if a debt consolidation loan is right for you.
What Is a Debt Consolidation Loan?
A debt consolidation loan pays off your existing debts and combines those balances into a single monthly bill with a new interest rate. The goal is to reduce the number of bills that you need to keep track of and reduce the total interest rate on your outstanding obligations.
These loans can be unsecured, meaning they’re guaranteed only by your promise to repay, or secured, meaning they’re tied to a physical asset – most often your home, but sometimes a retirement account, life insurance policy, car, or other valuable personal possession. Unsecured loans may only apply to unsecured debts, such as credit cards and medical bills. The proceeds from secured loans may be applied to a broader range of obligations, including mortgages and auto loans. Secured debt consolidation loans tend to have lower interest rates than unsecured.
Who Offers Debt Consolidation Loans?
Several different types of financial institutions offer debt consolidation loans:
Many debt consolidation loan providers are specialized lenders (also known as finance companies) that do not accept deposits like traditional banks and credit unions. They may pay off your old creditors directly, and then send you a monthly bill for the balance, or send you a check or direct deposit for the full amount.
Finance company credit history requirements may be less strict than those of traditional banks. However, their rates can be higher for borrowers with middling credit. Loan limits vary by company, but $25,000 to $35,000 is a common range. Limits have been trending upwards as competition increases.
Community and national banks including Wells Fargo, PNC, and U.S. Bank make secured and unsecured debt consolidation loans to borrowers with good credit. Rates vary widely by borrower creditworthiness and prevailing rates, but are generally at least 8% to 10% above the Prime Rate for those with the lowest acceptable credit score.
Bank loans usually require full repayment within 60 months. Borrowing limits can vary widely, from $25,000 or less at more conservative banks to $100,000 or more at more generous institutions. Larger loans are generally reserved for borrowers with excellent credit.
Credit unions also offer debt consolidation loans, usually with terms of 12 to 60 months, often at discounted or fixed rates for members. As an example, debt consolidation loans from UNIFY Federal Credit Union carry a flat 6.99% APR for prime borrowers. As at banks, borrowing limits vary widely, from less than $25,000 to $100,000 or more.
Peer-to-Peer Lending Services
Peer-to-peer (P2P) lending services, such as Prosper and Lending Club, facilitate unsecured loans between individuals and take a cut of the interest charged. Rates depend on your credit history and can range from as low as 6% to 8% APR for borrowers with excellent credit, to more than 30% APR for those on the opposite end of the spectrum.
Loan terms may be anywhere from 24 to 60 months, with larger amounts receiving the longest terms. Borrowing limits at Prosper and Lending Club top out at $40,000 for people with excellent credit. P2P loans are often the only quality option for borrowers with fair credit, who might otherwise feel pressure to turn to predatory payday loans.
Personal Lines of Credit From a Bank or Credit Union
Many banks and credit unions also offer unsecured lines of credit to qualified borrowers. Rates and limits are similar to debt consolidation loans from banks and credit unions, but credit lines generally don’t need to be repaid within 60 months.
An Alternative: Borrowing From Yourself
Taking out a debt consolidation loan requires you to borrow from a bank or other financial institution. However, some struggling borrowers choose to keep things closer to home and borrow from themselves with one of these options:
Depending on the specifics of your 401k plan, you may be able to borrow from it. You can borrow the lesser of $50,000 or 50% of your plan’s vested balance (the amount that your employer can’t take back if you leave your job). If your vested balance is between $10,000 and $20,000, you can take $10,000.
Like bank loans, 401k loans have a maximum term of 60 months. No credit check is required. You pay interest, typically at a rate close to prime, to yourself. One huge drawback of a 401k loan is that if you leave your job for any reason, you owe the loan’s entire balance within 60 days.
Borrowing From a Cash Value Life Insurance Policy
You may also be able to borrow from your cash value life insurance policy. Contact your specific insurer to understand how a policy loan affects your death benefit. These loans generally have lower rates, even for the credit-impaired, but may permanently affect the value of your investment.
Is a Debt Consolidation Loan Right for You?
Both secured and unsecured debt consolidation loans have common advantages: Simplifying your monthly debt payment schedule, lowering your interest rates relative to your old credit cards, and helping you rebuild your credit if you can make your payments on time. They also share a common disadvantage: While taking out a debt consolidation loan doesn’t automatically damage your credit score, simultaneously canceling all your credit cards after using a loan to pay off their balances – a common mistake – can lower it by up to 50 points per card, depending on your prior credit history.
Before you make any decisions, consider these category-specific advantages and disadvantages, as well:
Unsecured Loan Advantage
No Collateral Requirements
Unsecured debt consolidation loans don’t require you to put up assets as collateral, so you don’t stand to lose any physical property if you can’t repay.
Unsecured Loan Disadvantages
Higher Interest Rates
Since they’re not backed by collateral, unsecured debt consolidation loans are much riskier for lenders. As such, they usually come with higher interest rates.
If you have an excellent credit score (780+), the difference may be manageable relative to what you’d pay with a secured loan. With a lower credit score, your loan may be much more expensive than a secured loan, although it could still be better than the credit card it replaces.
If you can come up with the necessary collateral, a secured loan can help you increase the difference between your old credit card rate and your debt consolidation loan rate. Note that rates on P2P loans in particular can vary widely, ranging from a around 6% APR for top-rated borrowers, to upwards of 35% for bottom-rated first-timers – more than the penalty interest rate on many credit cards.
Strict Credit Requirements
If your credit score is below 650, it may be hard to qualify for an unsecured loan at a bank or credit union. While P2P lenders and finance companies do lend to borrowers with lower credit scores, their rates are likely to be much higher than on a secured loan, and possibly even higher than your old credit card. Your credit score also affects your loan’s size, so while you might qualify for a $30,000 or $50,000 loan if you have excellent credit (780+), you’re eligible for far less without that advantage.
Secured Loan Advantages
Lower Interest Rates
Although the exact rate depends on your credit score, loan size, and location, your secured debt consolidation loan is likely to be cheaper than an unsecured loan. For instance, APRs on a $30,000 home equity line of credit (HELOC) range from 3.5% to 6% for borrowers with an average credit score of 700.
Less Strict Qualification Requirements
Since your lender can repossess your collateral if you default on your loan, you don’t need a strong credit score. Some lenders accept scores of just 500. However, the amount you’re eligible for is limited by the value of your collateral.
Better Repayment Terms
Some secured loans have more lenient repayment requirements – home equity lines of credit sometimes allow balances to remain outstanding for up to 25 years. This can further reduce your monthly obligations and increase the likelihood that you can pay your bills.
Higher Borrowing Limits
Depending on the value of your collateral, you may be approved for a larger loan. Whereas lenders require excellent credit for unsecured loans of $30,000 or more, you can borrow upwards of 80% of your home’s equity for a secured loan.
Secured Loan Disadvantage
Potential Loss of Assets
Whenever you put up an asset as collateral – whether it’s your house, an insurance policy, or part of your retirement plan – you agree to forfeit it if you default on your loan. An unexpected job loss, medical bill, or death in the family could jeopardize your plans.
If you’re considering a debt consolidation loan, investigate these alternatives before making a final decision:
Credit counseling organizations, which often receive funding from banks and other financial institutions, provide free or low-cost financial education services to consumers.
Many credit counseling organizations also offer debt management plans, which are voluntary arrangements between borrowers and creditors that may help reduce interest rates, waive penalty fees, and consolidate balances into a single monthly bill.
Bear in mind that, should you cancel any credit cards as part of your debt management plan, your credit score could drop – how much depends on how many other credit cards you have and your total debt-to-credit ratio. A record of each cancellation may remain on your credit report for up to seven years.
Debt Settlement Programs
Similar to a debt management plan, a debt settlement program is brokered by an intermediary organization that negotiates balance reductions with your creditors. The process can take up to four years, during which you make monthly deposits into an escrow account in preparation for a lump-sum payoff of all participating debts.
Like debt management, debt settlement participation is voluntary, and the process can dramatically impact your credit score, to the tune of 100 points or more for borrowers who previously had good credit. For each settled debt, the record appears on your credit report for up to seven years.
Bankruptcy Reorganization or Liquidation
Chapter 13 creates a new payment plan for your unsecured debts, while Chapter 7 wipes away many of your unsecured debts and may require you to sell assets to repay your secured creditors. Your creditors are legally obligated to participate, although not all debts can be discharged in bankruptcy. Bankruptcy can have a serious effect on your credit score, and takes seven (Chapter 13) to 10 (Chapter 7) years to drop off your record.
Bankruptcy’s impact varies depending on your current credit score and recent history, but it can range from less than 100 points up to more than 200 points. If you previously had good credit, the net effect is likely to be worse.
Credit Card Balance Transfers
If you’re primarily struggling with credit card debt, transferring your high-interest balances to a card with a lower interest rate can make your situation more manageable. Many credit card companies offer introductory balance transfer rates – often as low as 0% – for new customers. These rates can last anywhere from 6 to 24 months, after which they reset to the card’s regular rate. Bear in mind that your balance transfer size is limited to your approved credit line.
Debt consolidation loans can help you pay off high-interest credit card bills, medical debts, and other obligations, and roll the balances into a single monthly payment, usually with a lower interest rate. When used judiciously, they can significantly reduce the total cost of your debt and help you create a sustainable budget.
However, debt consolidation loans come with many potential pitfalls, including the risk of asset loss on secured loans. Don’t take out a debt consolidation loan without weighing other options, such as credit card balance transfers and credit counseling. Plus, since debt consolidation loans are issued by a wide range of financial institutions, it pays to investigate lenders before making your decision. Use your local Better Business Bureau or consumer protection office for research, and stay away from organizations with a history of past complaints or legal action.
As always, speak with a financial advisor if you feel you need further guidance.
What’s your take on debt consolidation loans?