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Types Of Debt Consolidation Loans

Carl Andrews

Financial Advisor

If you are struggling to pay off your debts, then you may want to consider getting a debt consolidation loan. These loans allow you to combine your debts and get a lower interest rate. This will make it easier for you to manage your monthly expenses. There are several types of debt consolidation loans.

Home Equity Loans (HEL)

A home equity loan allows you to take out a loan and use your home equity as collateral. If you are not sure how to compute your home equity, simply subtract how much you owe in mortgage by the current value of your home. However, banks will not loan you the entire amount of your equity. At most, you can be granted up to 85%, but the exact percentage depends on your capacity to pay and your credit rating. That is why you will need to have good credit and a good amount of equity in order to qualify.

You may be able to get a loan at a lower fixed interest rate. This means that your monthly payments would be the same all throughout the life of the loan. However, the drawback is that your home will be on the line if you are not able to pay back the loan. With a home equity loan, you would be able to get the lump sum right away, but for a cost. Even if you do not use up the entire amount, the interest rate will still be based on the actual value loaned to you.

Home Equity Line of Credit (HELOC)

In many ways, a home equity line of credit is the same as a home equity loan. In fact, many people mistake them for one another because like the former, the collateral is the home equity. To make things easier to understand, think of HELOC like a credit card that has a collateral. You would be able to borrow a determined amount (but on HELOC, it is based on your home equity), and you can simply withdraw and use funds whenever you need them. Moreover, unlike HEL, it has a variable interest rate, meaning what you pay per month can go up or down.

Here, the interest only accrues on the amount you actually withdraw. Thus, even if your line of credit is $200,000, you would still only have to pay the interest on the arbitrary $10,000 that you actually used. You can get this if the debts you want to consolidate is not large enough to make HEL the more viable option. However, the potential losses here are bigger. Assuming that you do not use up all your credit, your house still gets repossessed.

Credit Card Balance Transfer

A credit card balance transfer allows you to put all of your credit card debt onto one credit card. This will allow you to get a lower interest rate. Keep in mind that many credit card companies will offer this low interest for a limited amount of time. You will need to have a credit card with a high limit in order to qualify for a credit card balance transfer.

Even then, consolidating your debts this way may be counterproductive if you fail to settle the remainder of the balance before the introductory rate expires. However, it will still work in your favor if the debts you are going to consolidate have higher interest rates. So, you will have the convenience, but don’t expect to save as much as you would if you opted HEL or HELOC. Remember also that there is a balance transfer fee which can either be a fixed amount or a percentage of what you are going to transfer.

Your credit score will likely drop after you get a balance transfer. Because balance transfers usually mean closing up some of your credit lines, your credit utilization percentage will increase thus causing your credit rating to suffer.

 

Personal Loan

If you take out a large personal loan, then you can use it to consolidate your debts. You will make fixed payments on the loan until you are able to pay it off. Your credit rating will determine whether you get approved for a personal loan. While it does not require you to put up a collateral, the annual percentage rate here is usually higher. No matter what your credit score, lenders will always deem investing in you to be riskier since there is no concrete assurance that you would be able to pay.

Cash Out Refinancing

Cash-out refinancing is generally considered a risky practice, but it can work in your favor if your credit rating has improved over time. Here, you replace your original mortgage with a bigger a newer debt, which of course would affect your credit score. For example, the equity in your home is $70 thousand. If you want to borrow that amount, you can do so but your mortgage will ‘absorb’ this new $70 thousand-debt. This can work on vehicles as well using the exact same principles as with your home equity.

401(k) Loan

Although many financial analysts consider this as a big no-no, it still is a viable option because of very low-interest rates. Moreover, because a credit check is not required for this type of loan, you only need to submit a 401k loan request. This is a great opportunity to pay off high-interest accounts, but if you are not able to pay it back, it means losing your retirement earnings. You can miss out on your company’s match funds and on the potential better growth of the amount that you loan.

Not all companies allow 401k loans and even if they do, there still are some things that you have to consider. If you get laid off way before your projected settlement of the total loan balance, you would have to pay it off within sixty days or risk defaulting on it. If left unpaid, it would be considered as taxable income. Aside from the withdrawal fee, you may not be able to contribute on your 401k until you have settled the remainder of the balance. Therefore, you would only choose this option if you have other investments to support you through retirement or if you have a structured plan on how you are going to pay it back.

Peer-to-peer Loan

In peer-to-peer loans, there is no bank or any for-profit organization involved. Instead, you transact almost directly with individual lenders who are registered with the mediating website like Lender. Here, the website performs a soft credit pull and asks for some basic information. From there, the lenders on the site would determine whether or not they would lend you money. The platform is not very strict with the credit rating and leaves the decision ultimately to the lenders. However, as in your brick and mortar places, a lower credit score generally means a higher interest rate. One of the perks lending here is that as soon as you and a lender come to an agreement, you can withdraw the funds almost immediately.

Debt Consolidation Loan

Many banks and credit unions offer debt consolidation loans. You have a number of options, so it is important to select the right one. Debt consolidation loans typically have lower interest rates. Keep in mind that if you get a lower monthly payment, then it will take you longer to pay off the loan.

How to Select a Debt Consolidation Loan

It is important to remember that a debt consolidation loan does not eliminate your debts. You are essentially shuffling the debt around and then making it easier to pay. Many people feel like they can borrow more because their monthly payments are smaller, but this is not the case. Make sure to practice financial discipline and to never borrow until the debt is completely paid off. You should also avoid loans and credit cards in general after you have paid off debt unless you really need it. If you have the right mindset so as not to fall into the same traps that got you here in the first place, ask these questions on how to select the best debt consolidation loan for you:

What is your credit score?

Your credit score can limit where you would be able to acquire a loan. If you want to go for an unsecured loan from banks, you must have an excellent credit score. Else, you would need to go online to search look for a loan. They have more relaxed requirements, although this means incurring higher interests as well.

Do you have a collateral?

If you do not have a collateral in place, you’d have to resort to unsecured debt consolidation loans like personal loans. Of course, this also means that you would not be able to borrow as much. Banks and other lenders are a little more conservative when it comes to unsecured debts. Moreover, having no collateral forces you to opt loans with relatively higher interest rates.

How much do you need?

Ideally, you would only borrow the exact amount you need to consolidate all your debts. However, this is rarely, if ever, the case. Still, remember that it does not make sense to put your equity on the line for a $10,000 debt. This may cause you to overspend and eventually lose your home.

Which debts are you going to consolidate?

If you are only going to roll your high-interest credit card debts, balance transfer doesn’t become too bad an idea because the annual percentage rate would like be only be playing around that area. However, if you plan to include relatively loans with relatively low-interest rates like your student loan or automobile loan, only HELOC or HEL would make sense.

 

Which institutions offer debt consolidation loans?

Finance companies

Unlike traditional banks and credit unions, you cannot open a savings account with them. Instead, you can avail of their debt management or debt settlement services. They negotiate with and pay off your creditors on your behalf, then send you a fixed monthly bill for the balance.

Banks

If you have a good credit rating, banks are a good place to get a debt consolidation loan. Their plans usually require that you settle the amount within 60 months (depending on the agreement). Failing to do so means losing your collateral for secured loans. There are borrowing limits that vary depending on your credit rating and other relevant financial records.

Peer-to-peer lending services

Websites like Lender and Prosper facilitate the transaction between the lender and you, then take a cut of the percentage charged to you. One disadvantage of this option over the other two items is the lower borrowing limits. Moreover, it is not available in some states like Maine, Iowa, and North Dakota. While they cater to opposite sides of the spectrum credit rating-wise, the interest rates can be a real burden as well, racking up to more than 30% per annum.

Credit Unions

These institutions are like banks, but with the lending policies a little more relaxed and the risk appetite a little different. Borrowing limits are generally the same with banks, but some credit unions like ABE Federal Credit Union offer a fixed interest rate on loans no matter what the credit rating.

What do lenders look at before approving you for a debt consolidation loan?

Character

This includes educational background and current income flow, among other things. For secured loans, this also includes the value of the collateral you want to put up.

Capacity to pay

This is not simply about how much you made last month. Here, your financial stability and perhaps even your household expenses are taken into account as well.

Credit rating

This sums up your financial history including how diligent you were in paying your debts, your debt-to-income ratio, how many loans you have defaulted on, and the likes. Most institutions generally rely on this single number to determine whether or not they would lend you money.