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"Capitalism without bankruptcy
is like Christianity without hell."

 Frank Borman
Types of Debt Consolidation and How They Work

If you’re drowning in debt, you have no doubt thought of the b-word: bankruptcy. And don’t kid yourself. It happens. You may eventually get past the point of no-return where bankruptcy is your only option.

Bankruptcy is not a great option. It never was, but it used to be somewhat better than it is today. Bankruptcy is going to scar your credit, diminish your reputation, and cause you to change your lifestyle. It’s a tough thing to overcome, and, frankly, some people never do dig their way back out.

Fortunately, there is something that may help you avoid bankruptcy. It won’t work for everyone, but there are some people who can use it to get back on their feet without ever having to undergo the trauma and tragedy of bankruptcy. It’s call a debt consolidation loan.

Consolidation is fancy word for “lump together.” In debt consolidation, all of your many smaller debts are lumped together into one large debt.

You may have tried to consolidate your debt on your own, particularly when it wasn’t so out of hand. For example, sometimes people with several credit card balances will do some balance transfers to get all of the debt onto one card at the lowest possible interest rate. The result: one monthly payment instead of several and that single payment is lower than the several would be if you added them together.

Not only that, one large debt is easier to manage mentally. You aren’t having to scramble to calculate how much you truly owe: it’s all in one place. You know how big the mountain is that you’ve got to climb—and that’s the first step in success. Besides that, one payment is just plain simpler. You’re not worrying all month about making a dozen or more payments on different dates—and the exorbitant late fees that can add up fast when you miss the due date, even by one day! You only use one stamp. And, best of all, you can often consolidate your many debts into a debt at a much lower interest rate. Instead of paying off several balances at interest rates that range from 14% to 16% to 18% to even 22%, you have on payment and maybe you can get an interest rate of 12%.

The cool thing about a lower interest rate is that it allows you to pay off the debt sooner. Let’s say you pay $1,000 every month toward your credit card debt and $800 goes to interest and $200 to principal. That means you only get rid of $200 in actual debt a month. But with a lower interest rate, now you still pay $1,000 a month, but only $400 goes to interest. That means you’re paying off $600 of the debt each month. You’ll pay off the debt three times sooner—without paying any more than you were before.

It’s no wonder rich people worry about stuff like interest rates!

But can you even get a debt consolidation loan? Would you qualify? That depends. But if you’re drowning in debt, you should start hunting them down! It may be all that stands between you and the dreaded b-word

Most debt consolidation loans come in three flavors:

  • The unsecured debt consolidation loan

  • Home equity debt consolidation

  • Mortgage

The unsecured debt consolidation loan means that you get a loan but the person or organization lending you the money does not have any collateral—that is property that belongs to you—that they would own in the event you don’t pay the loan. This loan is somewhat risky for the lender. If you don’t pay the loan, they do not have anything of value and can only hope to somehow legally collect from you.

The home equity debt consolidation loan and the mortgage refinancing both require you to own property, typically your home. If you don’t own a home, you won’t be able to get this kind of loan. Sometimes you can get a loan against other types of property—say you owned undeveloped land or a yacht—but in most cases, your house becomes your collateral.

What is the best kind of debt consolidation loan? They all have advantages and disadvantages.

The unsecured loan is also known as a “signature loan,” in that you get it on the strength of your signature (and credit report). You are not putting up any collateral, so that means the risk is less for you but most lenders are going to require good credit. A person with crummy credit is just not going to qualify for many unsecured loans. If you have good (or reasonably OK) credit, a good job, and a stable work history, it’s possible you can qualify for this loan. Basically, the bank or financial organization is just reorganizing and repackaging your debts for you.

The downside to this type of loan (besides the fact that you need good credit and a pretty decent-pahing job to qualify for most of them) is that the interest rate it charges is typically higher than the other forms of debt consolidation loan. But that only makes sense—unsecured loans always charge more interest than loans based on collateral.

A good candidate for an unsecured debt consolidation loan might be a young professional in a promising job, a couple of years out of college, who is starting to realize that five credit card payments and a student loan are more than she can manage. A poor candidate for an unsecured debt consolidation loan would be an unemployed person with no real job skills and horrible credit.

A home equity debt consolidation loan could be thought of as a flexible mortgage. Your house becomes your collateral and the loan amount is based on the amount of equity you have in your home. For instance, let’s say you own a $200,000 home (that is, you can reasonably anticipate that your home would sell for that amount) but you hold a $150,000 mortgage. The difference between what your house will bring on the market ($200,000) and what you’d have to pay off to the mortgage company if you sold it ($150,000) is $50,000. That amount is your equity.

The home equity loan is good for any amount up to and including your equity. But you only use what you need. Let’s say you have $50,000 equity in your house and you want to consolidate $28,000 in debts. You can borrow just that $28,000. Your home becomes your collateral and you make payments to the one loan until your $28,000 is paid off.

The downside of this loan is that you have to own a house to qualify. Regulations vary by state (so check out your local laws to see if you qualify), and you have to have equity in the house. If you just bought a house or if your house has lost value to the point that you’re “upside down” in the mortgage (meaning you owe more on the house than it’s worth or have a negative equity value), you won’t qualify.

On the plus side, interest rates should be lower than the unsecured debt consolidation loan (but still higher than a mortgage). Home equity debt consolidation loans are relatively easy to arrange for those that qualify, have the benefit of flexibility, and do not involve all of the paperwork that one gets involved with in the third type of debt consolidation loan.

The mortgage involves refinancing your house, which really means you work with a financial planner to get a new mortgage. (You are applying for a new mortgage loan and then using that money to pay off your old mortgage and put some extra cash in your pocket.) At current mortgage interest rates, this is generally the most advantageous solution. Your interest rate should be relatively low, especially if you have good credit.  If circumstances are in your favor, you may end up being able to pay off the debt with a loan that is less than the sum of your old mortgage and your various consolidated bills.

Of course, you need to qualify to make that kind of loan work. First, you need to own a house. Second, it helps (but is not required)  if you are refinancing from a higher-interest mortgage to a lower-interest one (that is, if interest was higher when you bought the house than it is today). It also helps if your house has appreciated in value. In other words, this loan works well for people who have a home that they have owned for a while. It’s more paperwork than a home equity debt consolidation loan and you’ll have to pay some loan origination and mortgage fees. However, there are some situations where this is by far the best option for debt consolidation.

But you need to talk to a financial expert. We recommend a certified credit counselor (read more about them in Article Bank).  Online information is great for background reading and to make you aware of what’s out there, what terminology you’ll run into, and what kind of options might be available. But only a real certified credit counselor—in your state—can help interpret your individual circumstances and your state’s laws and regulations in a way that arrives at the right decision for your unique situation.

Don’t give up online research. You need to do your homework. But don’t reach a decision on the type of debt consolidation loan you need without talking, face to face, to a real certified credit counselor.

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