Consumers use debt consolidation loans to pay off multiple existing loans, combining them into a single account requiring only one monthly payment. While convenience is usually the primary reason for a debt consolidation loan, such loans can save borrowers money when the interest rate is lower than that of the existing loans that it is replacing. Debt consolidation loans may generally be classified as secured or unsecured, depending on whether the loan is backed by collateral. The use of collateral in secured loans generally results in a lower interest rate than that of unsecured loans, all other factors being equal.
Homeowners have an advantage in consolidating their debt because they can use the equity in their home as collateral to refinance at a lower interest rate. Terms vary greatly among lenders, so it pays to shop around when looking for a debt consolidation loan in 2020.
Credit Cards
If you have no collateral for a secured loan, a credit card is a common, though not necessarily desirable, alternative means of consolidating debt. The high interest rates on credit card debt mean that you should probably consider this option only if you are able to pay off your debt within five years, and if your total debt is less than half your annual gross income.
Larger debt
Using a credit card for debt consolidation rarely makes sense if you have an exorbitant amount of debt. In that case, you should consult with a credit counselor or attorney on other options for reducing your debt, typically through a debt management plan or, in a worst-case scenario, bankruptcy.
Smaller debt
If your debt is of sufficient size to be worth consolidating on a credit card and you have a good credit rating, you should look for a zero-percent balance transfer card. This type of credit card doesn’t charge interest during an introductory period that typically ranges from six months to two years. The interest rate can be quite high after the introductory period, so you need to pay off your debt within that period to get the maximum benefit from this method of debt consolidation.
Unsecured personal loans are another option for consolidating debt. The rates are usually lower than those on regular credit cards, although the credit and income requirements are more stringent.
Home equity
The biggest advantage of using a home equity loan to consolidate debt is that the interest rate is usually much lower than for credit cards. Furthermore, the interest you pay on this type of loan may be tax-deductible, which isn’t the case for the interest you pay on credit cards.
Homeowners with good credit often have other viable debt consolidation options to consider that won’t put their homes at risk in the event of default. Borrowing against the equity in your house could cause you to owe more than your house is worth if it drops in value, a condition known as being upside-down. Yet another disadvantage of using home equity for debt consolidation is that secured debt is more difficult to discharge in a bankruptcy than unsecured debt. For all these reasons, you really shouldn’t convert unsecured loans to secured loans when consolidating debt, especially if your finances are shaky.
If you’ve weighed these pros and cons and decided that home equity is your best option for consolidating your debt, you will need to choose between a home equity loan and a home equity line of credit (HELOC).
Home equity loan
Home equity loans are a type of traditional secured loan that uses your home equity as collateral. The loan amount is limited to the value of your equity. Once the loan is approved, you receive a check from the lender for the entire loan amount, less closing costs. You can then use this money for any purpose, including debt consolidation. Like any other loan, home equity loans have a repayment schedule and a fixed monthly payment.
While interest rates are lower on home equity loans than on credit card debt, closing costs can be high depending on the lender.
HELOC
Unlike home equity loans, HELOCs are structured more like credit cards. Instead of a lump sum, you receive a line of credit equal to the loan amount. You can use this line of credit like a conventional credit card to pay off debt such as balances on other credit cards. You pay interest only on what you actually draw from the line of credit, and the interest rate is usually several percentage points lower than the rates charged on credit card debt.
One big advantage of a HELOC over a home equity loan is the lower closing costs. However, HELOCs usually have variable rates, making them harder to budget for if the rate goes up. Some lenders offer loan products that combine features of both home equity loans and HELOCs. For example, Figure’s Home Equity Line pays you the full amount of the loan upfront, but also allows you to continue drawing on your home equity as you pay off the amount you’ve borrowed. It also comes with a fixed* interest rate.
Summary
Consumers have a number of options for consolidating their debt, including secured and unsecured loans. It’s important to select the option that will provide the greatest benefit in the long run, so you need to develop a debt-consolidation plan before making a decision. Homeowners have the additional choice of using their home equity as a vehicle to improve their debt outlook.
*The Figure Home Equity Line is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw.
