Secured vs. Unsecured Debt Consolidation Loans

Debt consolidation can help you pay down multiple debts. It offers a way to combine them into one loan, simplify repayment, lower payments, and potentially save money on interest. 

But debt consolidation loans aren't one-size-fits-all. There are a variety of different types, including both secured and unsecured options. Before we get into the types, though, let's cover how debt consolidation works.

What is a debt consolidation loan?

A debt consolidation loan is a type of personal loan that lets you combine two or more debts into one. You use the new loan to pay off your old debts and have one monthly payment to make instead of several. You can use debt consolidation to lower monthly payments, lower your interest rate, or both. It's also a handy tool to replace a variable interest rate and variable monthly payments for a fixed rate and payment.

For example, if you have three credit cards with balances of $1,500, you could use a $4,500 debt consolidation loan to pay them all off. Ideally, the loan would have a lower interest rate than what you're paying on the credit cards.

Better yet, if you use an installment loan (like a secured or unsecured personal loan) to pay off credit cards, you could benefit from quick credit score gains. This is because high credit card balances increase your credit utilization ratio, which can damage your score. When you pay those balances off, your credit utilization drops and your score can improve.

Related: What Is Debt Consolidation?

Here's a closer look at the two main types of debt consolidation loans you may come across: secured and unsecured loans.

Secured debt consolidation loan

A secured debt consolidation loan is a loan backed by an asset, such as a vehicle or a home, known as collateral. If you default on the loan, the lender could seize the collateral to recoup its money. In exchange, a secured loan can have higher loan amounts and lower interest rates.

"Putting collateral up for a loan means that missed payments can result in loss of that property," says Ashley F. Morgan, a debt and bankruptcy lawyer at Ashley F. Morgan Law.

She recommends asking yourself: If you lost your job, would you be able to make payments on a secured debt till you found new employment? Would you be able to work part-time and get by until you find full-time work? If not, consider if you'd be okay with losing that asset in a worst-case scenario.

Unsecured debt consolidation loan

An unsecured debt consolidation loan doesn't require you to pledge any collateral. As a result, it can be harder to qualify for than a secured loan. Additionally, the lack of collateral tends to lead to lower loan amounts and higher interest rates.

"If a person is afraid of losing collateral, they might be more at ease with an unsecured option despite the higher costs," says Reilly Renwick, chief marketing officer at Pragmatic Mortgage. "Borrowers need to gauge their financial steadiness, availability of assets, and comfort with risk."

Secured debt consolidation loan options

While secured debt consolidation loans come in different forms, two of the most common are secured personal loans and home equity loans.

Secured personal loan

A secured personal loan provides a lump sum upfront for personal purposes, including debt consolidation. The loan amount is secured by collateral, such as a car, the funds in a savings or CD (certificate of deposit), or even the fixtures in your home. You may have anywhere from a few years to seven years to repay the loan; interest rates and payments are typically fixed.

Secured personal loans may take longer to approve and fund than unsecured loans since lenders typically need to evaluate or appraise the collateral. That said, they may not take as long to fund as a home equity loan.

Home equity loan or home equity line of credit (HELOC)

Home equity loans and home equity lines of credit are secured by the equity you've built in your home — your home's current market value minus the outstanding balance on your mortgage. Upon approval, you can take out a loan or line of credit and use it to pay off your debt balances.

If you opt for a home equity loan, you'll receive a lump sum and repay the loan amount through fixed payments over a set term, up to 30 years. On the other hand, a home equity line of credit (HELOC) grants you access to a revolving credit line for a set number of years, known as a draw period. During that time, you make interest-only payments on your outstanding balance. Once the draw period ends, you'll begin to pay back the entire balance (principal and interest) over the length of the repayment period.

Since your home serves as collateral in both cases, there's potential for larger loan amounts and lower interest rates. "Usually with secured loans, like a HELOC or a second mortgage, you are looking at interest rates between 7% to 11%," Morgan says.

By contrast, personal loan interest rates can range from about 7% to 36%.

Learn More: What Are Closing Costs in Real Estate Transactions?

Unsecured debt consolidation loan options

Next, let's take a look at three common types of unsecured debt consolidation loans.

Unsecured personal loan

Unsecured personal loans don't require collateral. Eligibility relies primarily on your credit and income. As with any type of personal loan, lender requirements for credit score and income can vary.

Check Out: Best Unsecured Personal Loans

Peer-to-peer loan

Peer-to-peer (P2P) loans allow you to borrow money from individual investors, often through an online platform. Investors review your application to decide if they want to fund your loan. A single loan could have multiple investors. If your loan gets approved, you receive the funds and pay it back through fixed payments over a set term. Investors receive a portion of your interest and payments.

Although it might be easier to get a P2P loan with fair to poor credit, their availability is limited.

Balance transfer credit card

Balance transfer credit cards allow you to use a revolving credit line to pay off outstanding debt balances. They often come with interest-free introductory offers that allow you to pay down your balance without interest charges for a period lasting from several months to nearly two years, depending on the card issuer.

Most cards come with balance transfer fees, however, often ranging from 3 to 5% of the amount transferred. The transfer fee is typically added to your balance. Regular APRs go into effect once the zero-interest introductory period ends.

Even if you can't qualify for a new card with a balance transfer offer, check existing cards for 0% APR offers.

Compare: Personal Loan vs. 0% APR Credit Card

Tips on choosing the best debt consolidation loan for you

The best type of debt consolidation loan for you depends on your situation and preferences. Here are the key factors to consider:

• Credit: Your credit plays a major role in both loan types, but poor to fair credit can be more of an obstacle when seeking unsecured loans. If you're struggling to get approved for an unsecured loan with an interest rate that can save you money, you may have better luck going the secured route because the collateral reduces the risk for the lender.
• Assets: With a secured loan, the lender puts a legal claim called a lien against the asset you're using as collateral. Consider if you have an asset that will qualify and if you're comfortable pledging it.
• Loan amount: The amount you can borrow with an unsecured loan is based primarily on your credit and income, while unsecured loans also consider the value of your collateral. If you're finding you can't borrow enough money with an unsecured loan, a secured loan may help you qualify for a larger loan amount.
• Borrowing costs: Secured loans tend to come with lower interest rates than unsecured loans, which may help you save on borrowing costs. However, a home equity loan may include costs such as an appraisal fee and document fee. Consider both the cost of fees and potential interest savings when evaluating which option is cheapest.
• Application process: If you want a loan fast, the application process for an unsecured loan will likely be faster because it won't involve the vetting of an asset.

You'll have to weigh the risks and benefits of your situation to decide which is best. A good place to start is collecting quotes to see the rates and terms that might be available to you. Remember, prequalification provides only an estimate and isn't an offer of credit. A loan offer itself may have different interest rates and terms.

"Beyond rates, the decision between a secured and unsecured debt consolidation loan often comes down to two key considerations: the borrower's financial situation and their risk tolerance," says Josh Richner, founder at FaithWorks Financial.

He says that if someone is in a strong financial position and seeking to optimize their debts by consolidating at a lower rate, a secured loan could make sense. However, for borrowers experiencing financial hardship, securing a loan with a major asset like a home can add to the pressure of the debt.

Read More:

• Best Debt Consolidation Loans
• Best Debt Consolidation Loans for Fair Credit
• How To Get a Debt Consolidation Loan With Bad Credit
• How To Consolidate Bills Into One Payment
• How To Get a Debt Consolidation Loan
• How Debt Consolidation Helps Your Credit
• Pros and Cons of Debt Consolidation