If your monthly bills are piling up and you’re feeling like there’s no way out, debt consolidation might be the right move for you. Debt consolidation rolls multiple debts into one low-interest, easy-to-manage payment. There are multiple ways to go about this, including taking out a home equity loan or a personal loan. Though these two loan products help you accomplish the same thing, they have some fundamental differences. Here’s what you should know about debt consolidation with these products.
Why Consolidate Your Debt?
Before we get into the different ways you can consolidate debt, let’s touch on why debt consolidation can save you money and give you a clearer path to debt freedom.
1. You’ll get a better interest rate.
One of the main goals of debt consolidation is to eliminate expensive debt. In other words, you’ll be paying off credit cards and loans with a high interest rate with a loan that has more favorable terms. Depending on your current rates and amount of debt, a lower interest rate could potentially save you thousands.
2. You’ll be paying far more than just minimum balances.
One of the biggest problems with credit cards and other high-interest loans is their very nature: the high interest. A lot of people with a large amount of debt can only afford to pay the minimum balance every month, and as more interest keeps getting added, the debt only gets larger. A home equity or personal loan will most likely have a lower interest charge, providing some relief and allowing you to actually pay down the debt.
3. There will only be one bill to worry about.
It can be overwhelming to think about owing money to a lot of different companies. A debt consolidation wraps it into one account and simplifies the payment process for you, making it easier to focus on paying off the debt.
Home Equity Loan vs. Personal Loan: What’s the Difference?
A home equity loan and personal loan are two loan products that borrowers often use to consolidate debt.
Pros and Cons of Using a Home Equity Loan for Debt Consolidation
If you are a homeowner that has over 20% equity in your home, you may qualify for a home equity loan. This type of loan uses your home as collateral. Lenders are assuming less risk because the loan is backed with your home, which means they’re free to offer better interest rates.
Equity is determined by subtracting your mortgage balance from the home’s value. The amount you’ll be able to borrow with a home equity loan will depend on how much of the house you’ve paid off. If your home has recently gained a lot of value, you may want to consider a cash-out refinance instead.
You’ll get a lower interest rate.
Interest rates are largely based on the risk a lender assumes by giving you money. The riskier the loan and borrower, the higher the interest rate typically is.
Because a home equity loan uses tangible property as collateral, a bank has a way to recoup their losses should you fail to pay. This makes a home equity loan less risky, allowing banks to offer a low interest rate.
You risk foreclosure if you can’t make payments. This is by far the largest factor to think about when considering a home equity loan. Since the loan is backed by your house, the bank can seize it if you default. With unsecured loans and credit cards, you do not run this risk.
Monthly payments may be smaller. Home equity loans typically have a longer term— sometimes up to 20 or 30 years. Longer loan terms translate to smaller monthly payments.
You could be underwater if your home’s value drops. If the market crashes or something else causes your home to drop in value, you could owe more on the home than it’s worth.
Closing costs are typically low. Many lenders charge a low, flat rate for home equity loan closing costs.
Home equity loans take longer to process. Because your home must be appraised, the application and approval process for a home equity loan can take a few weeks.
You must have adequate equity in your home. This means that this type of loan is not available for everyone. If you aren’t a homeowner or don’t have enough equity in your home, you won’t be able to get a home equity loan.
Pros and Cons of Using a Personal Loan for Debt Consolidation
Unlike a home equity loan, personal loans are unsecured, meaning you don’t have to put up anything as collateral. This makes them riskier for lenders, so they typically have higher rates than secured loans.
Personal loans are fixed-rate and can vary in term length. How much you can borrow depends on your financial standing, the lender, and the specific loan product.
Your home isn’t on the line. Since a personal loan is unsecured, you don’t risk losing your home if you can’t make your loan payments.
They have higher interest rates compared to home equity loans. Since the bank has no way to recoup their money should you fail to repay the loan, personal loan interest rates are usually higher.
Personal loans can be more flexible. Lenders have more leeway in crafting a personal loan, which means more options for borrowers.
You need a higher credit score to qualify. Because there’s nothing backing a personal loan, lenders will want to see a higher credit score. You may be able to get a loan with a less-than-stellar score, but it’ll likely come with a much higher interest rate.
You can get a loan quickly. Approval for personal loans is typically fast— sometimes only a matter of days.
Avoiding Going into More Debt
Debt consolidation doesn’t get rid of your debt— it simply lowers the interest you’ll pay and makes it easier to keep track of your monthly payments. Regardless of how you choose to consolidate, keep in mind that it will only help you in the long run if you make changes to the spending habits that led you into debt to begin with.
It’s important to consider whether or not you will be able to realistically repay your debt consolidation loan. If you can’t make that monthly payment, you risk digging yourself into a deeper hole.
Making the Right Decision
There’s no one-size-fits-all answer for debt consolidation. It all depends on your unique financial standing and the risks that you are willing to take. It’s worth consulting a financial advisor or loan officer to look at your specific financial situation. Considering the advantages and disadvantages to your options can help you determine which is right for you.