4 types of debt consolidation loans to avoid

Many Americans are faced with the personal finance challenge of overcoming student loan debt, credit card debt, and mortgage debt; so much so that some believe they may never be able to fully pay down their debt. Even if you have a significant balance across multiple loans, a personal loan allows you to pay down debt affordably and responsibly.

4 debt consolidation loans you should avoid

Choosing to consolidate debt into a single personal loan is usually a smart option for those who have several outstanding loans. Unfortunately, not all debt consolidation loans offer the same advantages. In fact, there are four loans that should be avoided when consolidating debt, including:

1. Loans with high-interest rates
2. Loans with high fees
3. 401(k) loans
4. Home equity loans

1. Loans with high-interest rates

Taking out a loan with a high-interest rate is inadvisable in most scenarios, especially when attempting to consolidate debt. Though average rates for a personal loan hover between 11% and 14%, you can find rates as low as 3.99% if you shop around. By comparing rates from multiple lenders, you can clearly identify the best rate available on the market and ensure that you’re not overpaying as you pay off debt.

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2. Loans with high fees

Before committing to a personal loan with a lower interest rate, it’s important to account for the other costs associated with the loan. Some lenders will offer personal loans with additional fees attached. One fee is an origination fee, which may also be listed as an “underwriting,” “administrative,” or “processing” fee. These fees could range as high as nearly 10%, unnecessarily increasing your repayment amount.

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3. 401(k) loans

If you’ve spent years investing in your 401(k), tapping into this savings account may seem like a reasonable option to pay down outstanding debt. It’s easy to view this as an opportunity to effectively borrow from yourself, and subsequently, repay it with the interest going back into your pocket.

Unfortunately, it’s not as simple as it may seem. Pulling money back out of your 401(k) can be a risky decision, as it jeopardizes your financial future in a number of ways. You may be forced to pay taxes or penalties on the amount borrowed if it isn’t repaid on time or if you lose/leave your job prior to loan repayment. You will also potentially reduce the overall amount matched by your company, preventing you from maximizing your retirement savings.

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4. Home equity loans

As you pay off your home mortgage loan, you’ll build equity in your house. This equity can be accessed via lump sums through a home equity loan. Many homeowners tap into this equity to renovate their homes or to cover emergency expenses.

However, home equity loans shouldn’t be used to pay down existing debt. A home equity loan ties the debt to the house itself, which means it can be foreclosed upon if you fail to repay the loan.

Using personal loans for debt consolidation

There are some pros and cons to using personal loans for debt consolidation. Here's what you need to know.

Pros

Debt consolidation through a personal loan can be advantageous when selected responsibly.

1. Lower cost of the loan: Consolidating multiple loans into a single loan with a low interest rate and low fees can reduce the overall cost of the loan.
2. It's easier to maintain: Not only can you save in total expenses, but a single loan is much easier to manage and maintain.
3. Help prevent late payments: Ultimately, this can prevent late or missed payments which will increase your overall expenses and potentially disrupt your other financial goals.

Cons

However, there are also some things to be cautious of.

1. Not all borrowers get the same perks: Although using a personal loan for debt consolidation can be a cost-effective option, not all borrows will receive the same benefits.
2. You may have a hard time getting approved: Factors like your credit score, debt-to-income ratio, and loan amount can impact the approval process, which means that a personal loan may not be the ideal consolidation strategy for debts such as high credit card balances.

According to Experian’s data, the average American has just over $6,000 in credit card debt. If you’re experiencing difficulties managing your credit card debt, you should also consider opening a balance transfer card to pay down your bills. A balance transfer card allows you to transfer your existing credit card debt to a new card with a lower APR.

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