What is the Best Kind of Debt Consolidation Loan?
If you are having problems managing multiple bills, a debt consolidation loan may be a good solution for you. A debt consolidation loan could give you a lower monthly payment, a longer time to repay the loan, and the ease of making only one payment on your debt.
There are variety of debt consolidation loans available. To find the right one for your situation, carefully weigh the pluses and minuses of these six debt consolidation loan options.
- Unsecured Consolidation Loan
Since the credit crunch that began a few years ago, fewer lenders are offering unsecured debt consolidation loans, but they do still exist. Your ability to qualify for an unsecured loan depends on several factors. You need to have good credit. Any lender will pull your credit, to examine if you have a history of repaying your debts on time. Don't expect to be approved for an unsecured debt consolidation loan if you have a low credit score. Another factor a lender will examine is your debt-to-income ratio (DTI). Your DTI is calculated by taking certain of your monthly debt payments (such as your vehicle loan, mortgage, student loan, etc.) and dividing it by your monthly income. If you have a DTI below 45%, you will have an easier time finding a loan than a person with a higher DTI, who may be refused a loan for that fact alone. Lenders also place weight on intangibles, including the length and strength of your relationship with the lender. A person who has a 30-year relationship with a local credit union may have better luck getting an unsecured loan than a stranger who applies for a signature loan from a national bank online.
- Vehicle Refinance
If you own a newer vehicle outright, consider a cash-out vehicle refinance. These are also known as title loans. These loans are offered by many providers ranging from mom-and-pop local used car dealers to nationally chartered banks. Interest rates and fees vary, so it pays to shop for the loan with the lowest interest rate and fees. The advantage of a title loan is that the interest rate can be a lot lower than rates available on unsecured signature loans, because the lender has a lower risk, because your vehicle is collateral that secures the loan. The disadvantage is precisely that; if you do not make your payments as agreed, you risk losing your vehicle to repossession.
- Cash-out refinance or HELOC
Using equity in a home is a popular type of debt consolidation loan. Tighter lending guidelines, along with a significant drop in property values in many parts of the country, have made this kind of secured debt consolidation loan more difficult to obtain. A cash-out refi or a HELOC requires good to excellent credit, strong DTI, and most importantly, significant equity in the home. The days of 100% financing are gone; most lenders do not offer cash-out financing above 80% of your home's value.
If you have equity in your home and your DTI and credit score meet lenders’ guidelines, a cash-out refi likely offers you the lowest interest rate long term financing possible.
Downsides of taking out a debt consolidation loan that uses your home equity include:
- Turning unsecured debt into secured debt. If you miss a payment on your secured debt, you will suffer financial harm of a late fee and a hike in your interest rate. If you miss a home payment, you place your home at risk of foreclosure.
- You may find yourself trapped in your home, if your home value drops below the amount you owe on your mortgage. You won't be able to sell the home, if you need to move due to a job relocation, a growth in the size of your family, or some other reason. Sadly, this has happened to many Americans, who currently find themselves in underwater properties.
- Peer-to-Peer Loan
Peer-to-peer (p2p) loans are, as the name suggests, loans between people that are mediated by a third party. In some p2p loans, the borrower writes a proposal and investors choose whether to fund the loan. In other p2p loans, an intermediary funds the loan, combines the loan with others, and sells shares in the loans to investors. I know of two companies facilitating peer-to-peer loans in the US today: Prosper and Lending Club. (Readers: If you know of others please comment below.) Consider a p2p loan as an alternative to bank financing.
- Credit Card Balance Transfer
Balance transfer and credit card convenience checks were common currency in the early 2000's when the economy was booming and credit card issuers battled for market share by issuing credit cards to every breathing being. Today, balance transfers and convenience checks are still available, but credit card issuers are pickier than they once were. Transfer offers today are often not at 0% interest rates, fixed for a 12 month period of time, as they were in the past. Instead, they may come with a higher interest rate and shorter period of time that the "teaser rate" is fixed.
If you decide to use a balance transfer or convenience check, your wisest choice is to commit yourself to paying more than the minimum on the new combined balance. Your goal should be to take advantage of the savings offered by the low interest by paying off the entire balance you transfer within the low-rate period. If you do not, the interest expense on the debt will cost you a great deal over the long run. Choose the balance transfer offer based on a the rate that is offered, how long the low rate lasts, and the fees that you are charged. Shop around; some balance transfers have a flat fee, some charge a percentage of the amount you transfer. Make sure that you know what your interest rate will be, once the initial teaser rate ends. Also, it is very important to not be a day late on any payment. One false step and your low interest rate will skyrocket to a rate as high as 29.99% interest or even higher!
- Credit Counseling/ Debt Settlement
These programs are not loans and they do not strictly consolidate your debt. If you qualify for any of the true debt consolidation programs above, they may be a better solution for you. If you can't qualify for a debt consolidation loan, you should look at other ways to solve your debt problem. While credit counseling and debt settlement are not debt consolidation programs, both do consolidate your payment; one payment you make to the program is used to take care of your debt.
- Debt settlement is an aggressive solution for people with a financial hardship who would like to achieve debt freedom in a relatively short period of time. In a debt settlement program, you choose to stop paying your creditors directly. Instead, your monthly payment deposit payments into a bank account that remains under your control, which the debt settlement company uses to negotiate lump-sum settlements with the creditors. Monthly payments in a settlement program are lower than your required minimum payments you are making to your creditors and the overall savings on your debt can be very significant. Downsides of debt settlement are harm to your credit score and the potential for aggressive collection actions from your creditors.
- Credit Counseling programs are another type of payment consolidation program. Credit counseling may be an effective solution if you have high interest rate debt and you can't qualify for a low interest debt consolidation loan. Credit counseling services offer Debt Management Plans that work to lower your interest rates and speed up the time it takes you to get out of debt. Downsides to credit counseling programs are that they have a high dropout rate and may not offer you much relief when it comes to the size of your required monthly payment.
There is no universal best answer for everyone who wants to consolidate debt. if you have good to excellent credit and own a home with equity, first look into cash-out mortgage refinance. If you own several expensive vehicles outright, consider a cash-out vehicle refinance. Unsecured and peer to peer loans are worth investigating, but may be hard to obtain. If you have high unsecured debt and poor credit scores, you may want to explore debt settlement or credit counseling. However, each consumer is different, so shop around to find the debt consolidation option that best fits your needs.