Secured vs. Unsecured Debt Consolidation Loans: What’s Right for You?

When people are overwhelmed with debt – particularly credit card debt – a debt consolidation loan is one solution. A debt consolidation loan combines several accounts into one monthly bill. Unlike credit card payments, a loan has a definite ending point, payments are the same every month, and interest doesn’t compound. The interest rate on a debt consolidation loan should be lower than credit card interest rates.

A debt consolidation loan may be a secured loan, which requires the borrower to provide collateral, or an unsecured loan where no collateral is required. Either one can be a debt consolidation solution, though both have potential financial drawbacks. Weighing the pros and cons of secured and unsecured debt consolidation loans against your individual finances will determine which is right for you.

Secured vs. Unsecured: Core Differences

A secured loan is one a borrower backs by agreeing to tie it to something they own. Common types of secured loans are mortgages and car loans. In both cases, the lender holds rights to the property until the loan is paid. If the borrower defaults, they lose the house or vehicle.

Other valuable assets – a savings or certificate of deposit account, jewelry, a boat, a life insurance policy – can also be used as collateral to secure a loan. While credit history, credit score and income still play a part, the collateral allows borrowers who don’t have good financial qualifications to get a loan.

With an unsecured loan, the borrower doesn’t put any assets at stake. The borrower’s agreement to pay the loan and record of financial reliability are what backs it. This means more financial risk for the lender, so unsecured loans often have higher interest rates and fees, and more limited terms. Credit cards are an example of unsecured loans. So are student loans and most personal loans.

The biggest drawback to a secured loan is that the borrower can lose the collateral if they fall behind on payments. Losing a house, car or savings account can have long-term negative effects on your finances. The biggest drawbacks to an unsecured loan are the probability you pay a higher interest rate, get less favorable payback terms and a lower loan amount. The worse a borrower’s credit and income, the more pronounced those drawbacks are.

What is a Debt Consolidation Loan?

A debt consolidation loan is a loan that combines multiple accounts into one. For instance, if you have several credit cards and medical bills that you want to pay off, a debt consolidation loan would be used to pay off the balances of those accounts, then you pay back the loan.

Ideally, a debt consolidation loan has a lower interest rate than the accounts it’s paying off. But even if it doesn’t, it comes with just one payment to keep track of and has a fixed repayment period, unlike credit cards. That makes it easier to manage as well as less expensive in the long run.

Debt consolidation loans are available from traditional lenders, like banks and credit unions, as well as from online lenders. Each lender has its own terms and qualifying standards. A designated debt consolidation loan differs from a personal loan in that the borrower and lender agree some or all of it is for debt consolidation. Some lenders offer lower interest rates on debt consolidation loans than personal loans since debt-to-income ratio will be reduced or at least not rise as much as with a personal loan. On the other hand, debt consolidation loans usually have shorter repayment timelines. Most are for five years or less and often have “origination” or “administration” fees that are added to the balance of the loan, meaning the borrower pays interest on the fees.

Most debt consolidation lenders require that a certain portion of the loan go to pay off debt. Once a debt consolidation loan is approved, most lenders pay creditors directly, though some allow the borrower to take care of it.

Pros and Cons of Secured Debt Consolidation Loans

A secured debt consolidation loan has advantages, including being easier to qualify for if your credit isn’t optimal, but also carries more financial risk than an unsecured loan. It also takes more time to get one, since the collateral must be appraised. A home equity loan or line of credit can take weeks or more to be approved.

Pros of Secured Debt Consolidation Loans

• Easier to qualify, with collateral
• Lower interest rates
• Possible longer repayment term means lower monthly payment
• Potential for higher loan amount
• Usually is not for a specific purpose and can be used for other things

Cons of Secured Debt Consolidation Loans

• Risk of losing the collateral
• May still be responsible for balance if borrower defaults and collateral doesn’t cover what’s owed
• Possible longer repayment term means more total interest paid
• Additional costs (appraisal, closing costs for home equity; fee for a vehicle title search
• Longer approval period.

Pros & Cons of Unsecured Debt Consolidation Loans

If your credit is strong and your income is enough to qualify for a debt consolidation loan, some lenders approve an unsecured debt consolidation loan so quickly you have the money the same day. Just make sure that it makes financial sense. Lenders usually require a percentage of a debt consolidation loan go to pay off debt, which should be a “pro,” but if you’re hoping to use it for other things as well, it could be a “con.”

Pros of Unsecured Debt Consolidation Loans

• No risk of losing collateral like home or car with a default
• Less stress from not having an asset tied up and at risk
• Easy and fast online application
• Faster disbursement and approval
• Lender usually directly pays creditors designated by the borrower

Cons of Unsecured Debt Consolidation Loans

• The weaker your credit or lower your income, the more difficult it is to qualify or get good terms
• Higher interest rates
• Shorter payoff terms, meaning higher monthly payments
• Lower borrowing limits
• Lender usually requires a specific amount go to debt payoff

Examples of Secured & Unsecured Loans Used for Debt Consolidation

There are a variety of both secured and unsecured debt consolidation loans to choose from. The best type of debt consolidation loan for you is the one that works with your financial situation and will attack your debt problem, not add to it.

Secured Loan Examples

Home Equity Loan or Home Equity Line of Credit [HELOC]. If you have equity in your home – it’s worth more than you owe – you can borrow up to 80% of the equity with an interest rate similar to current mortgage rates.

Secured Personal Loan. A personal loan backed with an asset, like a certificate of deposit account, boat, or jewelry.

Car Title Loan. The title of a vehicle [it must be paid off] secures a loan, usually for not more than 50% or less of the car’s value.

Life Insurance Loan. A loan secured by the cash value of a life insurance policy.

Unsecured Loan Examples

Unsecured Personal Loan. A loan from a bank, credit union or online lender with terms based on credit history, income, and debt-to-income ratio.

Peer-to-Peer Loan. Online lending that connects borrowers to individual lenders.

Balance Transfer Card. A credit card with an introductory zero interest period for balance transfers.

Personal Line of Credit. A revolving line of credit from a lender that can be reused as it’s paid back.

Who Might Be Best Suited for Each Option

Many factors go into deciding whether a secured or unsecured loan is your best option for debt consolidation. Some questions to ask yourself are:

• What collateral do you have and is it valuable enough to secure a loan?
• How well can you and your wallet tolerate the financial risk of a secured loan?
• How strong is your credit?
• How high and consistent is your income, and will it remain so?
• What is your debt-to-income ratio?
• How quickly do you need to get out of debt?
• How much of a monthly payment can you afford?

No individual financial situation is the same, so one person’s “best option” may not be yours. Let’s look at a couple of scenarios to illustrate how secured or unsecured debt consolidation loans can work in different situations.

Best Option is a Secured Loan

Angela has credit card, medical and student loan debt she wants to clear up. She’s a nurse, and her income is enough to cover bills, with a little left over. Her job situation is stable. She also owns a home. With her on-time payments, as well as sharp increase in home values, her equity is around $100,000.

Her credit history and credit score are fair, mostly because her debt-to-income ratio is high. If she could pay off her debt, she’d be in a better place financially, but her credit situation means she’s not a great candidate for a low-interest loan with good terms. Her home equity, though, puts her in a great position for a low-interest home equity loan.

Though she can borrow up to $80,000, Angela doesn’t need that much and wants to be sure the monthly payments don’t give her more financial stress. She borrows $40,000, at 6.99% interest. She pays off the credit cards, which had interest rates more than twice that, as well as her medical and student loan debt. She even had enough money left over to do some upgrades that will increase her home’s value. She has a manageable monthly payment, and her credit score is growing as she pays down her debt.

Best Option is an Unsecured Loan

Roland works full-time as a self-employed electrician. He pays his bills on time, but can’t afford a house. He used credit cards to pay for the tools and equipment to build his business. He’s also making payments on his work van, rent on a workspace. The good news is that he doesn’t have the added debt of a mortgage.

He makes all of his payments on time, paying more than the minimum on his credit cards. He really hates paying high interest on revolving credit, though, and would love to have some slack so he can put more money into his business, and maybe even save for a down payment on a house.

Roland doesn’t have collateral for a secured loan. The tools of his trade and his work van are valuable, but he can’t put his livelihood on the line. If he had an accident or got sick and couldn’t work – and therefore couldn’t pay the loan – he’d lose everything.

What he does have is excellent credit and a low debt-to-income ratio.

Roland applies for an unsecured debt consolidation loan with interest that’s a fraction of what he’s paying on his credit cards. He has one monthly payment that’s less than what he’d been paying every month. He now can save more money, and by the time his loan is paid off in five years, he’ll already have expanded his business.

Potential Pitfalls & Warnings

Both secured and unsecured debt consolidation loans carry potential pitfalls for borrowers who don’t consider their options carefully.

Default on a secured loan could mean home foreclosure, car repossession, or losing any valuable asset that was used to back the loan. The long-term effects of such losses can be much greater than losing just that one thing. It can impact credit and the ability to borrow for years. If the asset’s worth isn’t enough to cover what was owed, the borrower will likely have to pay the balance out of pocket.

Unsecured loans also have drawbacks. If the interest and fees are high, or the loan amount isn’t enough to cover the debts the borrower wanted to pay off, the loan can cost more than it’s worth. A short payment term can mean monthly payments too high for a borrower’s budget. Defaulting on the loan will significantly lower a borrower’s credit score.

There are also predatory lenders who make offers that may seem too good to be true. They likely are too good to be true, so do your homework, not only on your own finances and options, but on any lender you work with.

Alternatives to Debt Consolidation Loans

There are a lot of ways to consolidate or pay off high-interest credit cards and other debt. And if you’ve had enough of acquiring debt, your choices don’t all involve borrowing more money. Options are as simple as a DIY debt payoff plan or as extreme as filing for bankruptcy.

Some of the top alternatives to debt consolidation loans are:

• Consolidate Debt on Your Own. Create a budget, cut expenses, and target whatever you can afford at paying off your debt, one credit card at a time.
• Credit Counseling. A free discussion with a counselor at a nonprofit credit counseling agency can help you create a budget and understand your debt relief options.
• Debt Management Plans. A debt management plan with a nonprofit credit counseling agency can eliminate your debt in 3-5 years with one monthly payment and no hit to your credit report.
• Balance Transfers. A balance transfer credit card offers a zero interest introductory rate [usually for 12-18 months] for all transfers of other credit card balances.
• Negotiating With Creditors. If you have a history of on-time payments, contact your creditors and negotiate a lower interest rate, which will lower your monthly payments and make it easier to pay off the balance quickly.
• Bankruptcy. If your debt is beyond your means to pay, consider filing for bankruptcy, which will discharge your debt, but will stay on your credit report for 7-10 years.
• Debt Relief Programs. For-profit or nonprofit debt settlement pays a portion of your debt with the rest forgiven.

How to Choose What’s Right for You

Your finances and debt are unique to you. Choosing the right option will take some thought and homework on your part. Many people aren’t sure how much they owe or where they stand financially. You can’t choose a debt consolidation loan that’s right for you until you know how much you’ll need, how much you can afford to pay, and what it will cost.

The steps to choosing the right secured or unsecured debt consolidation loan, or other debt relief method, are:

1. Assess Your Full Debt Situation

Go through all of your most recent monthly credit card and other debt statements to get a clear picture of how much you owe. Get your credit report [it’s free] from each of the three credit reporting bureaus – Equifax, Experian, and Transunion. You can download them at annualcreditreport.com. Check to make sure there are no errors that are bringing down your credit score. All of the reports come with an easy process for reporting errors.

Knowing exactly how much you owe is key to applying for a debt consolidation loan. Understanding your credit will guide you to the right loan, too. Your credit score should be at least 620, and ideally higher, to qualify for a loan. Your debt-to-income ratio [percentage of monthly payments compared to gross income] should be less than 36%. The better those two numbers are, the better loan terms you’ll get.

2. Estimate What You Can Afford Monthly

Create a budget that includes your income, your necessary expenses [rent or mortgage, vehicle loan, groceries, utilities, etc.] and other monthly costs. Make sure you include everything. Take a serious look at what you can cut down on or eliminate. Ideally, you’ll have some money left over that you can aim at debt relief.

Once you’ve done that, add up your minimum credit card payments and other debt you want to eliminate. What you have available to pay monthly for a debt consolidation loan should at least equal that amount or be more.

3. Compare Interest Rates & Fees for Both Loan Types

Check out lenders online, as well as local credit unions and community banks, to compare APR, repayment lengths, and origination fee percentages on secured and unsecured loans. If they give a range for APR and fees, the lowest numbers are for the best credit scores. Also look for their qualifications. Some lenders require a minimum credit score or income.

If you’re searching for a secured loan that’s not a home equity loan or line of credit, it may be harder to get that information without making direct inquiries, because it will depend on the value of whatever specific asset you hope to use for collateral.

Be prepared if you put your phone number into any searches to immediately get inundated with texts, emails, and telephone calls from lenders. Ignore them. Don’t be pressured. Make up your mind by doing your research.

4. Evaluate What Collateral You Have and What You’re Willing to Risk

If you are in a position to put up collateral for a secured loan, be sure to evaluate its value first.

If you are applying for a home equity loan or line of credit, you can get an estimate on the market value of your home using a calculator on a real estate site like Zillow or Realtor.com. It’s a way to get a ballpark idea. You won’t have a real number until your home is appraised during the loan application process. Your mortgage lender can also provide an equity amount.

If you plan to use a vehicle as collateral, you can determine the value through Kelley Blue Book or Edmunds. Car title loans usually are between 25%-50% of the car’s value. If you want to use jewelry as collateral, a jeweler can give you an appraisal (don’t assume it’s worth the same amount you paid for it).

Any initial assessment you do may not be what a lender comes up with. Whatever you put up for collateral will be appraised once you apply, a service that you’ll have to pay for. For example, expect to pay $500 or more for a home appraisal.

Before applying for a home equity loan, or putting up your vehicle, life insurance, or another valuable asset, consider whether you can tolerate the risk. That doesn’t just mean how nervous it may make you, but also whether your finances can support the loan payments or survive the fallout if you can’t make payments.

5. Project Total Cost vs. Benefit of a Shorter Timeline

One cost factor to consider is a lower monthly payment with a longer-term loan vs. a higher monthly payment with a shorter term. The longer it takes to pay a loan off, the more you end up paying. It may seem like lower monthly payments are a good option, but paying a lot more over the life of a loan can get in the way of other financial goals, like saving for a down payment or building an emergency fund.

Let’s say your borrow $10,000 at 8% interest with a five-year payoff term. Your monthly payment is $202, but you’ll pay $2,165 in interest over the life of the loan. A three-year payoff would come with a $312 monthly payment and a total $1,281 in interest, a difference overall of $884.

The worse your credit, the higher the interest, and the bigger the difference. If that same loan had 18% interest, you’d pay $253 a month and a total of $5,386 over five years. A three-year loan would have a $361 monthly payment and a total of $3,014 in interest, a difference of $2,372.

If you have to take out a longer-term loan, pay extra on the principal whenever you can to shorten the length of the loan and the amount of interest that you’ll pay.

6. Get Pre-Qualified & Rate Quotes Without Harming Your Credit

You can get pre-qualified for a loan, or get rate quotes, without a hard credit pull. Too many hard pulls will lower your credit score, so you want to be sure to avoid that.

Your local bank or credit union has information on their website, usually a form to fill out online, on how to get prequalified or get a quote. Most online lenders also have a “check your rate” option. Check the details first to see if you qualify and if it’s a loan you’d want to pursue.

The information you get won’t be definitive but will give you an idea of what you may be able to borrow and what the terms will be. A lender can’t make a full determination until they look at your credit report [a hard pull] and also get proof of your income and assets.

Which Type of Debt Consolidation Loan is Right for You?

The type of debt consolidation loan that’s best for you comes down to your finances and situation. A secured loan is best for someone who has the collateral, can manage the risk, but may not have the best credit. An unsecured loan is best for someone who doesn’t have collateral, but has strong credit.

You have to think carefully about what you can afford, both in the short term and long run. Assess what type of loan will accomplish your goal of consolidating and managing your debt in the most affordable way.

It’s also important to look at the big picture when making a loan decision. What are your financial goals for the future? Will the loan help you achieve them or be a setback?

Understanding your debt and keeping track of your credit report and credit score is key no matter what option you choose. You may decide to work on your credit before applying for a loan. On-time payments and reducing debt-to-income ratio will go a long way to improving your credit score.

Talking to a counselor at a nonprofit credit counseling agency will help, too. Having a trained, neutral party review your finances with you, help you create a budget, and clarify the options can be a big step toward debt relief.