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Secured vs Unsecured Debt Consolidation Loan

It can be difficult to manage multiple debt accounts at the same time, but you may be able to remedy the situation with a debt consolidation loan. Easily available through traditional banks, credit unions, and online lenders, they come in two forms: secured and unsecured loans.

Both secured and unsecured debt consolidation loans can help you shave several months or even years off your repayment period. Additionally, you can save a bundle in interest by getting a debt consolidation loan with a more competitive interest rate and using it to eliminate your existing debt balances.

How a debt consolidation loan works

A debt consolidation loan is a personal loan that is used to convert multiple debt balances into a new loan product. You typically get a term of 1 to 10 years and a fixed monthly payment as the interest rate is fixed.

Ideally, the interest rate on a debt consolidation loan should be lower than what you currently have to maximize cost savings. But if you’re eligible for less than the total amount you owe on credit cards and loans, you should use the loan proceeds to pay off the highest-interest-rate debt.

Here’s an illustration of how a debt consolidation loan can save you a bunch on credit card interest:

  • Card 1: $1,500 balance and 17% APR
  • Card 2: $2,000 balance and 15% APR
  • Card 3: $2,500 balance and 12% APR
  • Card 4: $3,000 balance and 21% APR

Now let’s assume you pay off these balances in 24 months. You would spend $1,629 in interest. But if you’re approved for a $9,000 24-month personal loan at an 8 percent APR, your interest expense drops to $573.25.

You can use a personal loan calculator and a credit card payoff calculator to calculate potential interest savings with a debt consolidation loan.

How to use a secured loan for debt consolidation

Secured loans are backed by collateral, making them more risky for borrowers. Depending on your financial situation, they can be worthwhile. You can use any of these secured loan products for debt consolidation.

Secured Personal Loan

This works like a traditional loan and may be more accessible if you don’t have perfect credit. Still, there are downsides to consider. You could get a high interest rate and risk losing your collateral if you default on the loan payments.

Home Equity Loan or Home Equity Line of Credit (HELOC)

Both home equity loans and HELOCs allow you to convert some of your home’s equity, or the difference between your home’s value and what you currently owe, into cash.

When you take out a home equity loan, you receive the entire loan amount in one lump sum and pay it back in equal monthly installments because the interest rate is fixed. A HELOC acts as a credit card, and you can withdraw money from it when you need it. You only pay back what you borrow from a HELOC and the interest rate is variable.

Both home equity loans and HELOCs are ideal for debt consolidation because they offer more competitive interest rates than personal loans. Also, you could be approved for a large amount if you have a lot of equity in your home. The main disadvantage is losing your home to foreclosure if you default on the loan since these products act as second mortgages.

How to Use an Unsecured Debt Consolidation Loan

Unlike secured loans, there are no collateral requirements to be approved. There are two types of unsecured debt consolidation loans and a credit card option.

Unsecured Personal Loan

This loan product allows you to consolidate your debts to simplify the repayment process. You get a fixed interest rate and a more manageable monthly payment. Most lenders excel at fast approval and funding times. However, processing fees may apply when taking out a loan. Early repayment of the loan can also be subject to a prepayment penalty.

peer to peer lending

Unlike personal loans, they are offered by retail investors making unsecured loans to consumers who meet their lending criteria. You may be eligible for a loan with quick funding times even if you don’t have perfect credit. The downside is that if you have bad credit, your borrowing costs can be higher than if you took out a home equity loan. In addition, some peer-to-peer loans have short repayment terms.

Credit card transfer

You get an introductory period – typically up to 18 months – with a low or zero interest rate. Paying off your high-interest credit card debt and repaying it within this window will save you a fortune in interest.

How to get a debt consolidation loan

You can apply for a debt consolidation loan through a traditional bank, credit union, or online lender. Ideally, you should have a credit score in the mid-600s and a debt-to-income (DTI) ratio of no more than 45 percent for the best chance of qualifying for a loan with competitive terms. A lower credit rating does not automatically lead to a rejection, but you must expect higher borrowing costs and less favorable credit terms.

Remember that each lender has unique eligibility requirements, so it’s best to do some research before applying to make sure the lender you’re considering is a good fit.

bottom line

A debt consolidation loan makes managing multiple debt accounts easier, and you can pay off your balances faster and save a lot on interest. Before applying, evaluate secured and unsecured loans to decide which option is the best. It’s also important to shop around, pre-qualify without hurting your credit score, and review the numbers to determine if debt consolidation makes sense or whether you should wait until your credit score or overall financial situation improves.

Richard Dement

The author Richard Dement