Advantages and disadvantages of debt consolidation loans
Consumers struggling with high-interest debt have several options that can help them reduce their number of creditors and lower their interest rates. When used correctly, debt consolidation can help consumers get out of debt once and for all.
But before taking out a debt consolidation loan, consumers should first review their finances and assess what they can afford — as well as commit to not taking on more debt, said Joanne Kerstetter, a portfolio manager. word of International financial managementa non-profit financial services organization that advises people on how to get out of debt.
“If they opt for a consolidation loan, we advise them to know very well if it will be the best option for them,” Kerstetter said. “That includes asking them to take a look at their fixed expenses and debt – and making sure a consolidation loan makes sense.”
“The other thing is, if they get a consolidation loan, it’s really important for them to put their credit cards away so they don’t have a consolidation loan and keep billing,” Kerstetter said.
Although they can be an ideal solution for certain financial situations, debt consolidation loans are not without risk. Consider all the options before making your final decision, because making the wrong choice could potentially make your financial situation worse instead of better. Here are the three types of loans people commonly take out to consolidate their debt, and the top factors consumers should look out for before committing to a loan.
Read: 10 personal loans for people with good credit
A personal loan is generally an unsecured loan that is granted to the borrower based on their personal history and ability to repay the loan on the terms. A personal loan – sometimes used as a credit card debt consolidation or credit card consolidation loan – has advantages and disadvantages. Here are the details that could influence your decision on whether or not a personal loan is right for you.
Advantages: lower interest rates and wide availability
Personal loans offer a number of advantages, including the fact that they are offered by several sources. You can shop around for the best interest rates offered by physical banks, online banks, or peer-to-peer lenders like LendingTree or Prosper.
Other benefits of personal loans include:
- Lower interest rates: Personal loans may offer lower interest rates than you currently pay on credit cards or other high-interest debt.
- Better credit score: If you’re using a personal loan to consolidate debts like credit card debt — and as long as you pay on time — a personal loan can boost your credit score because you’ve reduced your debts to just one loan.
Related: When to Use a Credit Card or Personal Loan for Debt Consolidation
Disadvantages: higher interest rates and more
- Higher interest rates: Compared to a secured loan, interest rates on personal loans are often higher. However, this concern is often offset by the fact that you risk no assets should you default on the loan.
- Financial crutch: Taking out a personal loan won’t help you if you have bad financial habits and could simply act as a crutch that allows you to continue making bad financial decisions.
“Looking at the loan interest rate is really important,” Kerstetter said. “What we find is that sometimes people get loans and then…it doesn’t work for them, and then they end up using another credit card.” Before jumping into a personal loan, make sure the interest rate and monthly payments are affordable, Kerstetter said.
A home equity line of credit is a line of credit where borrowers are approved for a certain amount of money that can be borrowed over time, similar to a credit card. A HELOC is only a good option if the loan is properly managed.
Advantages: lower interest rates and flexibility
- Lower interest rates: A HELOC loan can be beneficial for borrowers looking to consolidate high-interest credit, as interest rates on HELOCs are generally lower than those on other loans.
- Revolving line of credit: As you repay what you have borrowed, your available credit will rotate and you can continue to borrow money. Best of all, you don’t have to reapply every time you need more money.
Cons: high risk and more
- Putting your home at risk: Because a HELOC loan is secured with your home, you risk losing this valuable asset if you are unable to service the loan. A HELOC is only a good option if the loan is properly managed.
- Increasing prices: If you have a variable rate HELOC and the prime rate goes up, your HELOC rate will also go up – so your monthly payment could go up because you’ll owe more interest based on the rate increase.
“We also caution people against taking out a home equity loan,” Kerstetter said. “It can have good tax implications, but it can also be dangerous because they are putting their only asset on the line.” If you default on your home equity, you can end up losing your home, Kerstetter said.
Retirement account loans
If you have a retirement account set up through your employer or an individual plan, you may be able to borrow from that retirement account to consolidate your debt. Borrowing from a 401k or other retirement account can be an effective strategy for getting out of debt; this attracts a lot of people because they are basically borrowing money from themselves and therefore making payments to themselves rather than another lender.
Pros: less paperwork and faster approval time
- Borrow from yourself: Borrowing from a retirement account is an attractive strategy because you’re essentially borrowing money from yourself and making payments to yourself instead of a traditional lender.
- Less paperwork and time required: Borrowing against your retirement savings is generally an easy process to implement and requires less time and paperwork than many other types of loans.
Disadvantages: taxes and loss of potential investment growth
- Loss of potential investment growth: By withdrawing your money from your savings, you will miss out on the potential compound interest you could earn and the potential investment growth that could take place.
- Potential tax debts: If you are unable to replace the borrowed money according to plan requirements, you will likely be subject to heavy penalties and taxes.
- Immediate reimbursement possibly required: If you leave your workplace before the end of the loan term, you may be required to repay the entire loan at once, regardless of your reason for leaving.
Read: Why you need to start treating your debt like an emergency
Choose your debt consolidation loan carefully
Debt consolidation could be the solution to all your money problems, or it could break you. The last thing you want is to be billed for a lump sum payment on a loan when you lose your job. Before committing to any type of loan that will consolidate your debts, you should carefully consider your alternatives before choosing a debt consolidation option.
Swapping multiple high-interest payments for one lower-interest payment makes financial sense, but only after considering all the pros and cons of the different types of consolidation loans. For example, it could be dangerous to swap unsecured debt for secured debt or to extend the term of your loans, depending on your financial situation.
No matter what you choose, the key is to change your spending habits and commit to living a debt-free life. Debt consolidation loans are a tool you can use to achieve your financial goals, not an answer to all financial problems.