Pros and Cons of Debt Consolidation Loans

Here are the advantages and disadvantages of three types of debt consolidation loans.

Consumers struggling with high-interest debt have several options available 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 look at their finances and assess what they can afford — as well as commit to not incurring more debt, said Joanne Kerstetter, a spokesperson for Money Management International, a nonprofit financial services organization that advises people on getting out of debt.

“If they’re going to go for a consolidation loan, we advise that they have a really good picture of whether this will be the best option for them,” Kerstetter said. “That includes having them take a look at their fixed expenses and a look at their debt load — and make sure that a consolidation loan makes sense.”

“The other thing is, if they get a consolidation loan it’s really important for them to put away their credit cards so they don’t have a consolidation loan and still keep charging,” said Kerstetter.

Although they can be an ideal solution for some financial situations, debt consolidation loans aren’t without risks. Consider all of the options before making your final decision because the wrong choice could potentially worsen your financial situation instead of making it better. Here are the three types of loans people commonly take out to consolidate debt, and the main factors consumers should look out for before committing to one.

Read: 10 Personal Loans for People With Good Credit

Personal Loans

A personal loan is usually an unsecured loan that is granted to the borrower based on his personal history and ability to repay the loan per the terms. A personal loan — sometimes used as a credit card debt consolidation or a credit card consolidation loan — offers advantages and disadvantages. Here are the details that might affect your decision on whether or not a personal loan is right for you.

Pros: Lower Interest Rates and Wide Availability

Personal loans offer a number of advantages, including the fact that they’re offered by a number of sources. You can shop around to find the best interest rates offered by brick-and-mortar banks, online banks or peer-to-peer lenders like LendingTree or Prosper.

Other advantages to personal loans include:

  • Lower interest rates: Personal loans can offer lower interest rates than what you are currently paying on credit cards or other high-interest debts.
  • Better credit score: If you use a personal loan to consolidate debts such as those from credit cards — and as long as you pay on time — a personal loan can increase your credit score because you’ve minimized your debts to just one loan.

Related: When to Use a Credit Card vs. Personal Loan for Debt Consolidation

Cons: Higher Interest Rates and More

  • Higher interest rates: Compared with a secured loan, interest rates on personal loans are often higher. However, this concern is often offset by the fact you are not risking any assets should you default on the loan.
  • Financial crutch: Taking on a personal loan won’t help if you have poor financial habits and might serve merely as a crutch that lets you keep making poor financial decisions.

“Looking at the interest rate of the loan is really important,” Kerstetter said. “What we find is that sometimes people will 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, be sure the interest rate and the monthly payments are affordable, Kerstetter said.

HELOC

home equity line of credit is a line of credit for which 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 managed properly.

Pros: Lower Interest Rates and Flexibility

  • Lower interest rates: A HELOC loan can be beneficial to borrowers who are looking to consolidate high-interest credit because interest rates on HELOCs are generally lower than other loans.
  • Revolving line of credit: As you repay what you borrowed, your available credit revolves, and you can continue to borrow money. Even better, you don’t need 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 satisfy the loan. A HELOC is only a good option if the loan is managed properly.
  • Increasing rates: If you have a variable-rate HELOC and the prime rate goes up, your HELOC rate will go up, too — so your monthly payment could increase because you will owe more interest based on the rate increase.

“We also caution people about taking out a home equity loan,” Kerstetter said. “It can have good tax implications but it can also be dangerous because they put their one asset on the line.” If you default on the home equity, you can end up losing your home, said Kerstetter.

Retirement Account Loans

If you have a retirement account set up through your employer or an individual plan, you might be able to borrow against that retirement account to consolidate debt. Borrowing from a 401k or other retirement account can be an effective strategy for getting out of debt; it appeals to many people because they are essentially borrowing money from themselves, and therefore making payments to themselves rather than some other lender.

Pros: Less Paperwork and Shorter Approval Time

  • Borrowing from yourself: Borrowing against a retirement account is an appealing strategy because you are 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 a process that’s generally easy to facilitate and requires less time and paperwork than many other types of loans.

Cons: Taxes and Loss of Potential Investment Growth

  • Loss of potential investment growth: By taking out your money from savings, you’ll miss out on potential compounded interest you could be earning and potential investment growth that could take place.
  • Potential tax liabilities: If you are unable to replace the borrowed money according to plan requirements, you’ll likely be subject to heavy penalties and taxes.
  • Immediate repayment possibly required: If you leave your place of employment before the loan term has ended, you might be required to pay back the entire loan at once — regardless of why you leave.

Read: Why You Need to Start Treating Your Debt Like an Emergency

Choose Your Debt Consolidation Loan Carefully

Consolidating debt could be the answer to all of your money problems — or it could break you. The last thing you want is to receive a bill for a balloon payment on a loan when you lose your job. Before you commit to any kind of loan that will consolidate your debts, you should carefully consider your alternatives before deciding on a debt consolidation option.

Trading in several high-interest payments for a single payment at a lower interest rate makes sound financial sense, but only after considering all of the advantages and disadvantages of the different consolidation loan types. For example, it could be dangerous to trade unsecured debt for secured debt or extend the length of your loans, depending on your financial circumstances.

No matter what you choose, the key is to make changes in your spending habits and commit to living a debt-free life. Debt-consolidation loans are a tool for you to use to achieve your financial goals, not an answer to all financial problems.