Millions of Americans make mistakes with their finances every year. Some may run into unforeseen expenses that drive them into debt, and others may overextend their credit. Whatever the reason, these individuals end up caught in a debt spiral that leaves them on the verge of bankruptcy.
Having debt collectors call you at home or work is both intimidating and embarrassing. When your finances go wrong, you could be fielding dozens of calls every month from collection agencies looking for money. This scenario is frustrating and takes a toll on your mental health.
Debt consolidation is one of the options available for people in debt with multiple creditors. With debt consolidation, you roll all of your outstanding credit into one loan with a single, convenient monthly payment. While this sounds like a fantastic way to sort out your finances, it has its drawbacks and benefits.
Let’s unpack the pros and cons of debt consolidation to see if it’s the right financial decision for you.
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The Debt Situation in The United States
Consumer debt in the United States is starting to reach troublesome levels. As of the first quarter of 2019, analysts measured total consumer debt at $14-trillion. This figure surpassed the $13-trillion of consumer debt at the previous market peak back in 2008. We all know how that ended for the economy and the American people.
The Great Financial Crisis of 2008 caused a wave of defaults compromising the securities underwriting the loans, leading to the biggest financial calamity in history. The crisis affected global markets, and the aftershocks remained for many years after.
Analysts also measure the per capita rate of consumer debt. In 2008, the average American accounted for $41.68 of the $13-trillion total. Today, that figure stands at $44.77, exceeding the ratio back in 2008.
The statistics show that Americans are drowning in debt, with no hope of relief in the future. A period of rising living costs and stagnant wages led to the development of an economic condition known as “stagflation.” Stagflation occurs when the cost of groceries, gas, rent, and utilities rise, but wages remain the same.
Therefore, it’s not surprising to see that Americans are struggling to manage their finances. When the money runs out, and we still have bills to pay, it’s easy to turn to a credit facility for help. Unfortunately, it’s a vicious cycle where Americans loan money to pay for lifestyle expenses and bills, and settle it with their paycheck, only to repeat the cycle.
Eventually, the interest payments and rising cost of living take an impact on the persons financial situation. As a result, they find they can no longer repay their creditors, and then must resort to bankruptcy to get out of the situation and start fresh.
Read: What Are the Best Balance Transfer Credit Cards? Complete Guide
Debt Consolidation Explained
When consumers land themselves in financial trouble, a debt consolidation loan can help them get their affairs back on track. With a debt consolidation loan, you roll all of your existing loans into one new facility.
The lender opening your account provides you with the funds you need to settle your other outstanding accounts. This transaction leaves you with only one payment to worry about at the end of the month. A single installment is easier to manage, and it prevents your creditors from lodging non-payment or late payment with the credit bureaus.
Receiving a non-payment or slow payment status with the credit bureaus hurts your credit score. By rolling all of your credit facilities into one account, you stop the reporting cycle and keep your credit score intact.
What is the Difference Between Secured and Unsecured Loans?
Lenders offer debt consolidation loans as unsecured or secured credit facilities. With an unsecured loan, the lender does not require any collateral to fund the deal. They open an account, provide you with the funds you need to settle your creditors, and then wait for your monthly payments.
If you default on an unsecured loan, the bank will still pursue you for settlement, or they might arrange the refinancing of the outstanding amount. Unsecured loans are preferable for the consumer market because there is less consumer risk in the loan. However, banks prefer secured loans where they can defer the risk in assets they can liquidate if you don’t pay your installments.
Secured loans are different from unsecured loans because the bank requires collateral to loan you the money. The lender may secure the loan value to your home or other assets they can liquidate if you default on the payments. Secur3ed loans have more risk for the consumer because the bank has direct access to foreclosing on the asset providing the collateral in the deal.
With unsecured loans, you can expect to get a higher APR. APR is the annual percentage rate of interest charged on your outstanding loan facility. Since the bank takes more risk with an unsecured deal, they often offer these loans at a higher interest rate than secured facilities.
Read: Payoff Review: Pay Off Your Credit Card With a Consolidation Loan
Using Secured Loans for Debt Consolidation
There are plenty of options for consolidating your debt using a secured loan. The most obvious place to start is by looking at assets you own with equity. Your home makes an excellent choice to help consolidate your debt. If you have money tied up in your real estate, you can refinance it and pay off your creditors. You could also take out a home equity line of credit as well.
Other assets that you can use to finance a debt consolidation loan are auto loans with your car as collateral in the deal. Many lenders will also provide you with a loan against your 401(k) or your permanent life insurance policy.
Secured Loans for Debt Consolidation Pros
The most significant advantage of using a secured loan facility is the lower interest payments. When the bank reduces their risk in the deal, they offer you a lower APR. By receiving a lower interest rate, the cost of the loan is less, helping you pay off your debt faster.
In some cases, interest payments are tax-deductible, but you should check with your accountant before confirming this is the case. Since secured loans carry less risk for the lender, they are willing to lower the interest rate.
Secured Loans for Debt Consolidation Cons
Consolidating your debt through a secured facility places the underlying assets in the deal at risk of seizure by the lender, in case of default. If you fail to meet your contractual obligations to the lender, they have the right to close the loan facility and liquidate the underlying asset.
As a result of experiencing a default, you run the risk of losing the asset. The lender may foreclose on your home, liquidate your insurance policies, or seize your retirement account to pay for the outstanding amount.
Some assets like life insurance and 401(k) plans may remain unavailable to you while you are paying off the loan. If you’re using your home to refinance, then the term of the deal may be far longer than the outstanding debts you currently owe. As a result, you end up paying more interest on the monthly installments than with a short-term loan facility.
Read: Avant Loans Review: Complete Guide to This Personal Loans Company
Using Unsecured Loans for Debt Consolidation
Unsecured loans were commonplace twenty years ago. However, the onset of the 2000 tech bubble burst, and the Great Financial Crisis of 2008, caused banks to be more cautious. Today, if you want to get an unsecured loan, you require good to excellent credit to receive the funding.
Unsecured loans carry more risk for the lender. Therefore, you can expect to pay a higher APR for the privilege of not pledging any collateral in the deal. However, even though there is no collateral in the loan, don’t mistake it as free money. The bank may still choose to come after your assets and liquidate them to pay off your debt in the case of a default.
Unsecured Loans for Debt Consolidation Pros
The most significant benefit of using an unsecured loan to consolidate your debt is that none of your assets are at immediate risk of liquidation if you default on your loan payments. By utilizing an unsecured loan, the bank assumes the majority of the risk. It’s for this reason that lenders only offer unsecured loans to customers with good credit scores.
Considering that you are in financial trouble, your credit score is probably on the low side. As a result, you will probably find it challenging to fi9nd a lender willing to write you an unsecured loan.
Unsecured Loans for Debt Consolidation Cons
With unsecured loans, the bank takes on a significant portion of the risk in the deal. As a result, the lender will likely want to mitigate this risk by setting the loan at a higher APR. You’ll end up paying more interest charges than you would with a secured debt consolidation loan.
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Debt consolidation or Debt Settlement?
Consolidating your debt means that you roll all of your outstanding loans into one loan facility. With debt settlement strategies, you employ the services of a debt counselor. The counselor negotiates with your creditors on a lower settlement amount that you owe.
Most creditors are willing to negotiate if they think there is a risk you will default on your payments. However, it’s important to note that you’ll have to pay the debt counselor for their services. These costs add to your debt levels.
Read: How to Erase Debt on Your Credit Report in Under a Year
Debt Management Planning
Debt counselors also sit with you and work out a budget you can afford to pay back your existing debt. They can help you evaluate areas of your budget that are costing you money, and then allocate those savings to paying off your debt.
Facilitated Debt Management
Facilitated debt management services offer the budgeting services of debt counselors. The service also allows you to send them money so that they can pay your debts for you. By adopting this strategy, the counselor controls your debt management affairs.
Facilitated services ensure that you don’t make any late payments to creditors. One late payment and you could lose the negotiated interest rate on your outstanding debt, increasing your monthly payments. By adhering to a debt management plan, you can get out of debt faster.
However, it’s important to note that debt facilitators also charge for their services. In most cases, the savings the facilitator makes on your interest rate and any amounts you owe, are enough to cover the fees for the facilitator.
Filing for Bankruptcy
Filing for bankruptcy is a scary thought for Americans. However, in some cases, it’s the only choice available. Most courts will do the best they can to avoid allowing you to file. If you’re trying to enter bankruptcy to avoid child support, alimony payments, or student loans, then you find the court’s ruling unfair.
These types of debt do not dissolve after filing for bankruptcy, and the creditors can still hold you liable for any money you owe.
Read: Bankruptcy Explained: How to File for Bankruptcy
The Final Thought – Are There Other Strategies to Help You Get Out of Debt?
Debt consolidation is one strategy to get you out from under the thumb of your financial affairs. However, there are other options to help you out of this pickle. Instead of going to the bank for a loan, try and see if you have family members that can help. If you don’t have a mortgage, and your parents do, then try refinancing to take advantage of the low APR on home loans.
Look at your lifestyle and examine areas when you can cut back on your expenses. The savings you make every month will help you find the money to meet your financial obligations. Getting a second job to increase your income is also a valid option. By raising your income, your debt-to-income ratio improves, and you can afford to pay off your creditors.
Whichever strategy you choose to pay down your debt, make sure it suits your earnings potential and your lifestyle.
