Debt consolidation is a form of debt relief that combines multiple debts into one account. Or, in other words, it uses one loan to pay off multiple loans. In some cases, this provides unique benefits to the consumer and can be a viable option. And for some, it’s an appealing option when other loans aren’t available due to bad credit. In general, though, debt consolidation lengthens repayment, costs more, and puts the consumer at risk. The worst kind of consolidation is secured debt consolidation because this poses even more risk. Secured debt consolidation involves using an asset, such as a home or vehicle, as “security” for the loan. While this makes the loan less risky for banks, it’s much more risky for consumers. Why? Because consumers lose the asset if they fail to repay the loan! We are going to cover some types of secured debt consolidation and explain in more depth why it’s usually a bad idea.
Types of Secured Debt Consolidation Loans
Let’s take a closer look at what types of collateral can be used in secured consolidation loans. Below are the types of collateral along with different ways they can be used in the debt consolidation process.
Consumers can use their homes or other real estate as collateral when obtaining a consolidation loan. A home is often considered a consumer’s most important financial asset, so this can be considered a high-risk loan.
Home Equity Loans
A home equity loan can be used as a form of debt consolidation, although this isn’t always the case. It works by using the equity in your home (the value of your home that you already own by paying toward your mortgage) to provide cash. In a traditional home equity loan, this comes as a lump sum, but in a home equity line of credit this comes as a revolving credit account. This cash can be used for just about any expense, but by taking the cash you are also taking out a loan to pay that cash back.
This is used as debt consolidation when you use the funds to pay off debt, such as credit card accounts. In essence, you have moved these credit accounts into a new loan—your home equity loan. The credit accounts likely have high interest rates, above 15 percent, but the home equity loan will be lower, maybe around eight percent, for example. As a result, you have basically cut your credit card interest rates in half. But keep in mind that you are likely also lengthening the repayment.
Cash Out Refinancing
This option is very similar to a home equity loan and can also be used as a form of secured debt consolidation. There are a few key differences, though. In a home equity loan, you keep your original mortgage and take out a second loan. This is not the case with cash out refinancing. In cash out refinancing, you actually replace your first mortgage with a new, larger mortgage. For instance, if you wanted to liquidate $50k of your equity to cash, this $50k would be added to the total remaining mortgage balance in the form of a new loan.
Cash Out Financing
We’ve already covered this concept, but it can be applied toward vehicles too. If you have equity in your car, you might be able to turn that into cash and replace the amount with a new loan. Essentially, you refinance the vehicle at the amount it is worth. For example:
Your car is worth $12,000 but you only owe $8,000. Let’s say you want to get quick cash, in the amount of $4,000 (equity), maybe to pay down credit card debt or take care of repairs. If eligible, you could refinance a new loan of $12,000.
While this is still generally considered a risky financial practice, it can provide benefits if your credit score has significantly improved since taking out the first loan. Why? Because banks and other lenders use your credit score to determine the interest rates you are charged. If your credit score has improved, refinancing could get you a much lower rate and end up saving you money. And, you can use the cash to pay off any outstanding high-interest accounts.
The problem here is that you are creating a bigger loan for yourself, which could potentially put you in a deeper financial hole. A better solution would be to budget carefully and have an emergency fund in place to cover car repairs and other unexpected expenses.
This method, when done with a bank or credit union, typically requires decent to good credit.
Car title loans are the “payday loans” of the auto industry. Like with payday loans, title loans often don’t require a credit check and present consumers with astronomical interest rates and APRs. Also, just like with payday loans, consumers can quickly find themselves in a vicious cycle, where the only way to get out of one title loan is to roll it into another. But the biggest difference from payday loans is that there is collateral at stake—your car!
Surprisingly, recent research from Vanderbilt shows that less than 10 percent of vehicles used in title loan programs are repossessed. This number is lower than many experts might have predicted, but it doesn’t mean that title loans are a good idea. Those who use this lending option can end up paying thousands more than the amount of the original loan.
People often use title loans when they have an urgent and unexpected expense; it’s not typically a go-to consolidation option. If safer loans or refinancing options aren’t available, consumers may panic and make the choice to use a title loan. It’s best to first consider all other options, including communicating directly with creditors about the situation, making arrangements for a hardship program, and talking to representatives at credit unions or banks about safer lending options.
If you’re a fan of reality television, you might already know about the ins and outs of pawning. What you may not realize though is how much money this can cost in the long-run. Pawning involves trading in items of value for cash. The amount received is often far less than retail value, and is sometimes even far less than resell value. The main benefit is that the transaction can happen quickly, and you have an opportunity to get your item back. Doing this will require the consumer to pay hefty interest and service fees, often referred to generically as “finance charges.”
This is not typically used for “consolidation” per se, but it could be. For instance, several small credit balances could be paid off using this method. More commonly, pawning is used in a pinch, to generate some quick cash for an unexpected expense. Like with other types of consolidation, smart planning and an emergency fund are better options. In this case, selling the items online could be a better option as well, unless it’s an item of sentimental value that is “worth” the extra cost via interest.
Consumers can create their own form of secured debt consolidation by borrowing from their 401k. While this is typically a “last resort” of sorts, there are situations where it may make sense, and in many ways it presents less risk than other consolidation options.
The specifics of this type of consolidation may depend on the company that services your 401k and the policies of your employer. No credit check is required for a 401k loan. The potential borrower usually just needs to submit a 401k loan request to initiate the process.
This low interest loan can be used to pay off high interest accounts, anything from high credit card debt to student loans. Due to IRS regulations, interest will be charged on the loan, but it is paid back into the 401k so that the money continues to grow (although its growth is likely less than its usual return on investment).
Of course, the opportunity cost of this consolidation (what you’re missing out on) is the ability for that money to grow, at a higher rate. The policy varies by company, but those who cannot contribute to their 401k while the loan is active are at an even greater disadvantage. In fact, a report from Fidelity claimed that a $30,000 loan could cost a borrower $600,000 in the long run if that borrower does not continue to make contributions during the loan period. For this reason, consumers on firm financial footing who have a realistic debt-to-income ratio should not consider this option. But, it can be feasible for those in deep high-interest debt.
There are a few disadvantages to this method. First, if you leave your employer or are laid off, you may have to repay the loan on short-notice, often within 60 days, or pay taxes on the remaining balance along with withdrawal penalties (these are the normal repercussions of a 401k withdrawal, which is different than a 401k loan). The other disadvantage is that certain companies do not allow contributions during the loan period. When this is the case, your savings will not be able to grow as quickly and you may pay more in taxes since you will be able to shelter less money in your 401k. One way to leverage this disadvantage is to put more money toward the loan itself.
Given these disadvantages, the best use of this form of debt consolidation is to pay down any high-interest accounts immediately, so that you can restart your retirement contributions as soon as possible.
The Pros and Cons of Secured Debt Consolidation
The pros and cons of secured debt consolidation are very similar to unsecured consolidation, with the added element of collateral.
We could sum up the pros as follows:
- Can be used to get a lower interest rate or a fixed interest rate
- Can provide the convenience of just managing one account and making one payment
The cons of secured debt consolidation include:
- Puts assets at risk
- Uncertain implications for credit score. Can improve credit score when debts are paid off but can also damage credit score if utilization increases on the new account.
- Can lengthen repayment, leading to higher costs
Alternatives to Secured Debt Consolidation
There are better ways to take care of unsecured, high-interest debt than rolling them into a loan that jeopardizes important financial assets. The first way is to budget effectively, have an emergency fund for unexpected expenses, and maximize the amount of money you put toward the debt each month. The problem is, that if you’re already struggling financially this isn’t realistic.
A better option would be to communicate your situation to your creditors—let them know what’s going on and find out what arrangements can be made. You might just qualify for a hardship program that could make your financial burden a little lighter.
If this isn’t available, or if it doesn’t provide enough help, the best option just might be a debt management plan. Unlike consolidation, a DMP doesn’t risk assets, it allows you to build a healthy credit history, and it gets you the lower interest rates you need to survive month-to-month. It’s operated by nonprofit credit counselors who provide the tips and tools you need to increase savings, pay down debt, and create a healthy financial future.
If this sounds like it could help you, speak with a credit counselor for a free review of your financial situation.