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How Debt Consolidation Works

Debt Consolidating Loan Options

Knowing all your options is important before making a major financial decision. You don't want to entangle yourself in an agreement only to find out you have sunk deeper into debt.

Your first step is to decide whether you want a secured or unsecured loan. A secured loan occurs when a valuable asset, such as a house or a car, serves as collateral in case you, the debtor, stop making payments (known as default). If default occurs, then the company that loaned the money can legally repossess your house or car. In contrast, an unsecured loan merely uses the debtor's credit to back the loan. Because of the collateral, companies are willing to offer lower interest rates with a secured loan. You'll have to decide whether lower interest rates are worth the risk of losing your home or car.

Next, decide if you want to:

  1. get a consolidation loan with a bank or finance company,
  2. take out a second mortgage or
  3. take advantage of credit card offers.

Going through a bank is often the best way to get a consolidation loan [source: Wilmington Trust]. You usually can qualify for a lower interest rate from many banks if you can deduct payments from an account you have with them. If you have a low credit score, which is an indicator of how creditworthy you are based on your payment history, banks are less willing to fork over cash. This is why many debt-ridden people turn to finance companies.

Finance companies are simply companies that offer loans to individuals or businesses. They often are willing to take more risks and lend money to people with lower credit scores. In exchange for that risk, they typically charge high interest rates. Many non-profit companies offer debt management as well. They will help you find a debt consolidation loan and provide counseling. Remember that even though they are non-profit doesn't mean there won't be fees attached to some of their services.

If the first option for managing your debt doesn't appeal to you, you could try taking out a home equity loan. This is a secured loan, also known as a second mortgage, in which your house serves as collateral. Despite the risk of losing your home, this kind of loan has some advantages. For one, you can deduct the interest payments on your taxes. You also can get a fixed interest rate (as opposed to a variable interest rate, which may rise) with a home equity loan.

Another option for consolidating your debt is using credit card offers. Many credit card companies advertise 0 percent balance transfer fees -- you can bring over the old credit card debt with no charge. Some people pay off debts by jumping from one low-rate introductory offer to another. To avoid hurting your credit when you close accounts, ask the company to report the account as being closed at your request [source: Dunleavey]. You also might consider leaving these accounts open, even if you won't use them, because it will improve your debt-to-credit ratio.

If those old student loans are still hanging over you, read the next section to learn about some of the special rules that apply to consolidating them.