The Two Main Pitfalls Of A Secured Debt Consolidation Loan

A secured debt consolidation loan is often the only choice that people have when it comes to consolidating their debts in this manner. Why? Well, the answer is quite simple.

Most people who are looking for a loan to consolidate their debts, already have a significant amount of credit (and debt of course), and are likely already struggling to pay that debt off. And because of this, the reality is that there are not many banks willing to lend more money to them without some guarantee that the money will be paid back. And that guarantee usually comes in the form of a "secured" loan.

By far the most common types of secured loans are the ones that use people's homes as collateral. Home equity loans, HELOCS and cash out refi-mortgages are all popular. People routinely borrow against their home to pay off debts such as credit cards, medical bills and signature loans. In other words, they take out secured debt consolidation loans in order to pay off their unsecured debt. But is this a good idea?

Are Debt Consolidation Loans In General A Good Idea?

There are many financial experts that will argue that any type of debt consolidation loan is a bad idea, regardless of whether it is secured or not. Their argument is based on the fact that consolidation loans do nothing to deal with the underlying reasons why people get into debt troubles in the first place. They also will tell you that many people who use debt consolidation loans to pay off existing debt (such as credit cards) end up back in credit card debt in a short period of time.

Personally, I agree with these experts. Before you ever consider an unsecured or secured debt consolidation loan, you should deal with the underlying reasons that you are in debt trouble in the first place. Conducting (or having a professional credit counselor conduct for you) a thorough personal financial review followed by the preparation of a complete budget is an essential first step. Proving to yourself that you can stick to your budget is the next step before any consolidating loans should be pursued.

In addition to these issues however, there are two other issues that arise when talking about a secure debt consolidation loan.

Is Using Secured Debt Consolidation Loans To Pay Off Other Unsecured Debt A Good Idea?

Once you "trade" your unsecured debts (like credit card debt), for secured debt (like a mortgage) you essentially take one very effective debt reduction method (debt settlement) off the table and you will lose that money if you end up filing Chapter 7 bankruptcy. Let's look at both in more detail.

A Secured Debt Consolidation Loan And Debt Settlement

Due to changes in the bankruptcy laws a few years back, it is now more difficult to qualify for bankruptcy, or Chapter 7 bankruptcy to be more precise. As a result, debt settlement, (which involves negotiating settlements with your unsecured creditors for less than what is owed), has become more common. Debt settlement can be an effective debt elimination tool, but once your debts are secured by an asset, this method is no longer possible. Therefore, paying your credit card debts off using a home equity loan for example, virtually eliminates your ability to negotiate a settlement of the debt.

'So what' you say? Well, consider the fact that in many instances, debt settlement can reduce the amount of debt that you have to pay back by up to 75%. At the very least you would be doing yourself a favor by leaving this option on the table. A secured debt consolidation loan does not allow you to do this.

A Secured Debt Consolidation Loan And Chapter 7 Bankruptcy

In most states, even if you file for Chapter 7 bankruptcy (often called liquidation bankruptcy) you are still able to keep some of the equity in your home. For example, if your home is worth $250,000 and the mortgages and loans secured by the property total $200,000, in some states you get to keep that $50,000 in equity. On the other hand, if you took out a home equity loan for $25,000 to pay off your credit card debts, and then filed for bankruptcy at a later date, you would only keep $25,000 in home equity. Had you not used a secure debt consolidation loan to pay off the $25,000 credit card debt, it would have been wiped out in the bankruptcy filing. But because it is now secured by your home, that debt would not be wiped out.

There are many things to consider before securing a debt consolidation loan, whether it be secured or unsecured. As I mentioned earlier, a good first step is to analyze your finances thoroughly and prepare a budget for yourself before you do anything else. If you are not sure how to do this, seeking the help of a professional credit counselor can be very productive.