In this blog I would like to clearly define debt consolidation loans and how they function to lighten your load while simultaneously making your lender money. Secondly, I want to provide you with some real examples where each can be effective and where they can act as a detriment to your long term financial situation. If you have any questions, please leave them in the comment box at the bottom of this article or, if you prefer to discuss specific details about your individual situation, request a free consultation.
Debt consolidation loans function by paying off multiple debts with one loan. You will then be left with one loan payment, hopefully at a lower interest rate. There are two common types of debt consolidation loans often used to receive these benefits: unsecured debt consolidation loans and home equity loans.
An unsecured debt consolidation loan involves you taking out a personal loan and using it to pay off your unsecured debts. From that point on you will make one monthly payment toward this loan. This option is managed and executed by you; no guidance or help is provided from a third party company or professional.
To pursue this option you need a good credit score in order to be approved and secure a low enough interest rate. This type of loan is not secured against any asset or collateral, increasing the risk for lenders. You will need to prove you are responsible, trustworthy and capable of making full and timely payments. This can be difficult to achieve if you are experiencing financial turmoil.
In order for this to be a beneficial option for your finances, the interest rate must be low enough to decrease your total monthly payments. In order for this to make sense for your lender, they offer an extended payment timeline. Typically, debtors who choose to take out an unsecured debt consolidation loan experience short term relief but end up making payments for a longer period of time, which results in you paying more money after all is said and done.
This option doesn’t eliminate your debt; an unsecured debt consolidation loan merely moves your debt from one place to another. It may simplify your payment process and give you extra breathing room if you are able to lower your monthly payment. But if you are already in financial trouble, this may just lengthen an already stressful situation.
A home equity loan functions the same as an unsecured debt consolidation loan but it requires you to secure the debt against your home. This reduces the risk of the lender, simultaneously increasing your risk, because if you can’t make payments they can take your house.
The reduced risk also lowers the credit score requirement. Your credit score doesn’t need to be great in order to be approved for a home equity loan. This component makes this option attractive to debtors because credit scores suffer during poor financial times. For the same reason, this is a very dangerous option for debtors because securing your debts put you at greater risk of more significant damage. If you fail to keep up payments on secured debts, your losses and consequences will be much greater.
This is a highly risky option for paying off unsecured debt because you run the risk of losing your home. Home equity loans need to be managed and executed by you, with no third party involvement. It is not a recommended plan for dealing with financial difficulty.
There are alternative debt solutions for dealing with struggling financial situations, which offer many of the same benefits as debt consolidation loans. A Chapter 13 bankruptcy allows you to prioritize your debts and pay off what you can afford. (And at the end of a limited plan length – 3-5 years, whatever unsecured debt is not paid off, gets wiped out, tax free!) It is very similar to many debt consolidation plans, but gives you the breathing room you need to get back on your feet.
Download our free eBook, The Truth About Debt Consolidation, to learn more about the dangers and risks involved with the various debt consolidation options that exist. This eBook also further explains Chapter 13 bankruptcy, an alternative solution that may be able to relieve your financial distress.