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Secured vs. Unsecured Debt Consolidation Loans

Carl Andrews

Financial Advisor
Updated: 12/2017

Debt consolidation replaces multiple debts with one larger loan. This means that you only need to make a single payment each month. In addition to easier record-keeping and fewer payments, you will probably benefit from a reduced interest rate. Many people consolidate credit card or hospital debts. This financial solution doesn’t change the principal, and it usually improves or has no effect on a person’s credit score.

Unsecured or Secured Loan?

Different debt consolidation loans may be secured or unsecured. Like credit cards and cash advances, unsecured loans don’t require any collateral. The lender normally can’t seize any possessions if you neglect to repay a loan. However, it may expect a higher credit score, ask for a co-signer or charge more interest.

On the other hand, secured loans necessitate valuable property. You will need to sign an agreement that establishes certain possessions as collateral. For instance, a lender may be willing to secure the loan with your vehicle, business or house. It gains the right to take ownership of this property if you repeatedly fail to make the monthly payments that are needed to repay a loan.

Unsecured Debt Consolidation Loans

Lenders don’t offer to consolidate debt with unsecured loans as often as they did in the past. A person must maintain a rather high credit score to qualify. Consequently, some individuals use credit cards with minimal introductory interest rates to consolidate debts. This reduces the number of monthly payments and decreases the finance charges at least temporarily.

What are the different types of unsecured debt consolidation loans?

Personal loans

You can actually consolidate your debts on your own, and one of the ways you can do so is by taking out a personal loan. One of the advantages of this is you do not have to get a professional or an agency to mediate the transaction. Instead, you can just apply for a personal loan with your local bank. There is not usually a lot of documentation required aside from IDs, but you do need to have a high credit score. If you feel that this is the best way for you to consolidate your debts, you can ask if you can have the loan cosigned by someone with a better rating.

Balance transfer

Done with credit cards most of the time, it can be a great way to save a lot through minimal or even zero introductory rates, given that you can pay off the amount before that period ends. This, too, simplifies the payment process because you’d only be looking at one bill every month. However, there are usually hefty balance transfer charges depending on the credit card provider. So, be careful because, in the long run, you might end up paying even more.

Line of credit

While this can be a secured loan as well (we’ll discuss this later on), it is usually unsecured. Depending on your credit rating and income, they would set a maximum amount that you can borrow. However, you cannot just go to a random bank to apply for this unless you have an excellent credit rating and incredibly high income. Else, it is ideal to only go to financial institutions you already have an account with.

Peer to peer loans

Instead of borrowing from a business or an institution, you borrow from individuals instead. However, in this case, there is a mediator like Prosper and Lending Club. Individual lenders have their own risk appetite, so while it still follows that bad credit means higher interest rates, it is still up to the lender whether or not he will reject your proposal. One advantage of this over going to banks is the process is much quicker. In fact, these websites/mediators claim that as soon as an agreement is reached, you will have access to the cash in 24 hours.

Cash advance

Generally, there are two types of cash advance: on your income and on your credit limit. Unless you really are desperate, it is not advisable to get a cash advance if the annual percentage of your card is already high as it is. The interest rate here is even higher. And unlike your credit card debt, you are required to pay your cash advance for the next billing cycle.

Payday loan

A payday loan is where people borrow money to cover currently unpaid expenses until the next paycheck.  This has gained popularity because it is very convenient, but it does come with high transaction fees and interest rates, with some businesses charging up to 400%.

Term loans

Term loans are offered by banks and other financial institutions, and the amount borrowed is a product of the negotiations between the lender and the lendee. Here, there is a specific repayment schedule that must be followed which can either be weekly, bi-monthly, or monthly. The interest rate varies as well, depending on your credit score.

Disadvantages of Unsecured Consolidation Loans

Unfortunately, this type of credit is unavailable to the majority of individuals who want to consolidate debts. The interest rate on an unsecured loan is often comparatively high as well. Even if you have a credit score near 700, NerdWallet reports that rates range from about 5 to 25 percent. Consolidation may not greatly improve your finances if you still need to pay a considerable amount of interest.

If you decide to transfer debts to a credit card with a low introductory rate, you’ll need to watch out for various pitfalls. You could have to pay even more interest after the introductory phase comes to an end, especially if the card has an adjustable rate. Try to pay off the debt before this occurs. Be aware that you may also need to pay an extra fee to transfer the debt from one card to another.

Advantages of Unsecured Debt Consolidation

If you qualify for an unsecured loan, there’s a decent chance that you can benefit from a somewhat lower interest rate than you currently pay. Another desirable aspect of these loans is that you don’t have to worry about a bank repossessing your assets. Even if it would be easy for you to make the monthly payments, keep in mind that unforeseen events could reduce your income at any time.

 

Secured Debt Consolidation Loans

Several different types of secured lending are available. Home equity and vehicles aren’t the only options for collateral on a loan or line of credit. You could use your 401(k), an annuity or the cash value of your life insurance. Almost any major asset or guaranteed income source may be utilized as collateral when you borrow money to consolidate debts.

What are the different types of secured debt consolidation loans?

Home equity loan

One of the biggest mistakes people make is assuming that with a home equity loan, you would be awarded the full monetary worth of your house. Unless you have paid up your mortgage, this is not the case. To calculate your home’s equity, subtract the amount you owe from mortgage and the property’s current value. Still, the amount that the bank would let you borrow is not a hundred percent of your home’s equity. Depending on your financial track record, you can get as much as 85% of your equity value. Here, the interest rate is fixed and you get the lump sum right away. Moreover, the interest you pay is tax deductible. That leaves you with a lot of cash to pay off your current debts. However, if the value of your home suddenly declines, you could end up paying more than what your house is actually worth.

Home equity line of credit

Home equity loan (HEL) and home equity line of credit (HELOC) are actually similar because you are borrowing with your home equity on the line. However, there are a few key differences, and which is better between the two depends on your case. For one, you do not get the lump sum and only draw funds as you need them. Also, the interest rate is variable, meaning your monthly payments can go up or down depending on the economy. Lastly, you only pay the interest rate on the amount you actually borrowed. Even if your line of credit is a million dollars, you would only have to pay the interest on $5,000 if that is the amount withdrawn.

401(k) loans

While it is not recommended, you can use your retirement funds now to consolidate your debt. An estimated 20% of Americans actually have taken from their 401(k). This is easily accessible and has low-interest rates, but defaulting on it comes with consequences. The obvious one, of course, is you miss out on the potential growth of the fund which you will use when you retire. Because of that too, you potentially miss out on the company’s matching funds. Moreover, some plans prohibit you from contributing to your 401(k) until the loan is settled. The biggest burden perhaps with defaulting is being taxed because the outstanding balance would be considered as income. Moreover, you would be charged with an early withdrawal fee if you are aged 59.5 or below. However, if you are sure that you can settle the amount right away, it is a great way to access a low-interest loan.

Certificates of deposit and Savings-secured loans

You can also use your certificates of deposit (CD) and savings account as collateral to secure a loan. Most of the time, this does not make any sense because you can simply withdraw the amount you need and use it instead of taking out a loan. However, if you are sure that you can pay what you borrowed back, it makes sense. This means that you do not need to take out any cash, which perhaps can better help you budget because you know you need to pay your debt. Moreover, CDs usually cannot be withdrawn before its maturity. So, if you need cash right away, you can put it up against your loan. Remember though that you may not be allowed to touch those collateral accounts up until the full balance has already been settled.

Drawbacks of Secured Consolidation

This type of loan carries a major risk. The lender will take action to seize the collateral if you stop making payments. You may lose ownership of your life insurance policy, vehicle, retirement savings or real estate property. This might happen as a result of unemployment, medical problems or other hardships. A secured consolidation loan could also restrict access to 401(k) funds or life insurance benefits until it is repaid.

Reasons to Consolidate Using Secured Loans

You won’t need an especially high credit rating or annual income to qualify for this kind of loan. Secured consolidation loans frequently feature far lower rates than credit cards, according to Discover. You may be able to deduct interest charges from your taxable income, especially if the collateral is a house or business.

People often feel much better about life after consolidating their debts. Fewer bills and a lower rate can free up substantial amounts of money for other important purposes. Nevertheless, it’s vital to remain cautious and avoid accumulating more debt.