Secured or unsecured debt consolidation loan

It can be difficult to manage multiple debt accounts at once, but you may be able to find relief with a debt consolidation loan. They are readily available from traditional banks, credit unions and online lenders and come in two forms: secured and unsecured loans.

Secured and unsecured debt consolidation loans can help cut months or even years off your repayment period. Plus, you can save a lot of 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 used to convert multiple debt balances into a new loan product. You will usually get a loan term of one to 10 years and a fixed monthly payment because 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 qualify for less than the total amount you owe on credit cards and loans, consider using loan proceeds on debts with the highest interest rates.

Here is an illustration of how to use a debt consolidation loan to save a bundle 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, suppose you pay off those balances in 24 months. You would spend $1,629 in interest. But if you’re approved for a $9,000 24-month personal loan with an 8% APR, your interest charges will drop to $573.25.

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

How to Use a Secured Loan for Debt Consolidation

Secured loans are backed by collateral, which makes them riskier for borrowers. However, they may be worth it, depending on your financial situation. You can use any of these secured loan products for debt consolidation.

Secured personal loan

It works like a traditional loan and may be easier to access if you have less than perfect credit. Still, there are downsides to consider. You could get a high interest rate and risk losing your collateral if you fall behind on loan repayments.

Home equity loan or home equity line of credit (HELOC)

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.

If you take out a home equity loan, you will receive the entire amount you borrow in one lump sum and repay in equal monthly installments since the interest rate is fixed. A HELOC acts like a credit card and you can withdraw funds from it as needed. You will only repay what you borrow from a HELOC, and the interest rate is variable.

Home equity loans and HELOCs are ideal for debt consolidation because they offer more competitive interest rates than you’ll find with personal loans. Additionally, you might get approved for a significant amount if you have a lot of equity in your home. The main disadvantage is losing your home to foreclosure if you fail to repay the loan, as these products act like second mortgages.

How to Use an Unsecured Loan for Debt Consolidation

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

Unsecured personal loan

This loan product allows you to consolidate your debts to simplify the repayment process. You’ll get a fixed interest rate and a more manageable monthly payment. Most lenders offer quick approval and financing times. However, you may incur origination fees if you take out a loan. You may also be subject to a prepayment penalty if you decide to prepay the loan.

Loan between individuals

Unlike personal loans, they are offered by individual investors who provide unsecured loans to consumers who meet their lending criteria. You may be eligible for a loan with fast funding times, even if you don’t have perfect credit. The downside is that your borrowing costs may be higher with bad credit than they would be if you had taken out a home equity loan. Additionally, some peer-to-peer loans come with short repayment periods.

Balance transfer credit card

You’ll get an introductory period – usually up to 18 months – with little or no interest. If it’s used to pay off your high-interest credit card debt and paid off within that window, you’ll save a fortune in interest.

How to get a debt consolidation loan

You can apply for a debt consolidation loan from a traditional bank, credit union, or online lender. Ideally, you should have a credit score in the mid-600s and a debt-to-income ratio (DTI) that does not exceed 45% to have the best chance of qualifying for a loan on competitive terms. A lower credit score will not automatically result in a denial, but you can expect higher borrowing costs and less favorable loan terms.

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

At the end of the line

A debt consolidation loan makes it easier to manage multiple debt accounts, and you can pay off your balances faster and save a ton in interest. Before applying, evaluate secured and unsecured loans to decide which option is better. It’s equally important to shop around, get pre-qualified without impacting your credit score, and crunch the numbers to determine if debt consolidation makes sense or if you should wait until your credit or your overall financial situation is improving.

Michael M. Tomlin