Does Debt Consolidation Have Risks?

Chloe Meltzer

February 25, 2021

Don't go to jail over your debt.

Summary: Debt consolidation might feel like the only way out. But is it all it's cracked up to be? Find out if it's a smart idea to start paying off your accounts with debt consolidation.

Like many other people all over the country, you may be struggling financially. Although this is common, there are solutions. Some may seem like an easy way out, but they are not always the best options to choose.

Whether you have one major debt, you are going into foreclosure on your home, or even considering bankruptcy you may have heard of debt consolidation. If you are struggling with paying off multiple debts then you may be considering debt consolidation. Before you decide to do this, you must understand the advantages and disadvantages that come with debt consolidation as well as the risks and rewards.

How Debt Consolidation Works

When you decide to consolidate your debt it turns multiple loans or payments into one single loan. This provides you the ability to pay off all of your debt in one large monthly payment, rather than struggle to organize all of your different payments.

The purpose of debt consolidation is to make your life easier. The thought is that if you have one payment, it will be easier to focus and pay off that debt. Typically debt consolidation also allows you to lower the interest rate, reduce your monthly payment, and ultimately pay off your debt more quickly.

It is important to note that a debt settlement is not the same thing as debt consolidation. Debt consolidation has less risk than a settlement. It allows you to pay your debt completely without negative consequences to your credit report.

Debt consolidation is different depending on whether you have a secured or an unsecured loan.

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Secured vs. Unsecured Loans

If you are looking to understand debt consolidation options, then you also need to understand the difference between a secured and unsecured loan.

Secured Loans — Mortgages and Car Loans

Mortgages and car loans are considered secure loans. When you take out a secured loan, you pledge your property. With a mortgage, you are offering your house in exchange for the debt if you do not pay it, and the same as with a car for a car loan.

Essentially, when you obtain a mortgage loan, your house is offered as security to that loan officer. If you fall behind in your debt, a foreclosure will occur to repay the loan officer for the loan.

Unsecured Loans — Credit Card Debt, Medical Debt

Unsecured loans are based on your promise to repay them. Although they are not secured by any property, typically they are offered based on your credit history. An example of an unsecured loan is a credit card. This is why a credit card carries a higher interest rate because there is more risk if you decide not to pay it back.

Secured Loans — Mortgages, Auto Loans

When looking to consolidate your debt there are many options using a secured loan. This means that you can choose to refinance your house, take out a second mortgage, or obtain a home equity line of credit. You can also take out a car loan, or use your car as collateral, or if you have a life insurance policy with cash value, you might be able to obtain a loan against that policy.

Putting up your house or car to pay off your loan is a risk. Consider the fact that you may not be able to pay off your debt consolidation loan and then you lose your home in the process? Although you can also use a 401K to use your retirement as collateral, you are putting your future at risk.

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Pros and Cons of Debt Consolidation with a Secured Loan

There are some positive aspects of consolidating with a secured loan. Secured loans typically have lower interest rates which will allow you to lower your overall payment, and save money in the long run. Interest rates can also be tax-deductible meaning any interest paid on a real estate loan will be considered a tax deduction.

When you consider paying one monthly payment with a lower interest rate versus many with different rates, you will save money. It is easier to obtain a secured loan because there is less risk of default. Despite this, there are many risks with debt consolidation under a secured loan as well.

One of the major risks associated with consolidating unsecured loans into one secured loan is that you put your property at risk. Whether this is concerning your home, car, 401K, or whatever your collateral is, you run the risk of losing this property.

Since you already have a history of not paying your debt, do you trust yourself to do a better job of paying this debt? Certain assets, such as life insurance or retirement funds may no longer be available to you if you do not pay the loan back, or until you pay the loan back. This not only puts yourself at risk but also your family.

Consolidated loan debts are typically going to be longer terms than the original debts. This means that although you may have already paid off the debt originally, you will be continuing to pay the loan, along with interest. Even though your monthly payment is lower, you do run the risk of paying more in the long run.

Debt Consolidation with an Unsecured Loan

Unsecured personal debt consolidation loans are less common than they were in years past. If you want to have any chance of consolidating your debt with an unsecured loan, then you will need to have a great credit profile. Good credit and debt consolidation don't typically go hand in hand, therefore this is not at all common anymore.

FInding a no-interest, or low-interest rate on a credit card is typically the best way to obtain an unsecured personal loan to consolidate debt.

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Pros and Cons of Unsecured Debt Consolidation

You might want to consider consolidating your debt with an unsecured loan (or a credit card) if you have multiple credit cards that you haven't paid off. This is your best chance of combining them into one bill and having something like 15 months to pay them off without interest.

The main risk that comes with debt consolidation on an unsecured loan is that other than a credit card, it may be impossible to get without great credit. Overall you may dig yourself deeper into a hole that you cannot get out of.

Make a Plan to Tackle Debt Consolidation

Debt is something many people struggle with. But the only way to get out of debt is to make a plan. Decide on whether debt consolidation, debt settlement, or another method is the best way out of your situation. Be sure to do your research, and in the end, you should come to a solution that is right for you.

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