Why you may need a debt consolidation loan

It started out innocent. Twenty dollars here, ten dollars there, all charged to your credit card. And those in store specials: "Get a store charge card and and save 15% all day today! Even on sale items!" The next thing you know, you have multiple credit cards with differing amount of debt on them, all at different interest rates. It is all you can do to pay off the minimum payment for each one. One way out is to consolidate your debts.

What is a debt consolidation loan?

A debt consolidation loan is used to combine all of your debt into one loan. So, you total all of the outstanding debt on your credit cards and get a loan for that amount. You use this loan money to pay off all of the credit cards. Now your credit cards are free and clear and you are left with only one debt payment.

Ideally, at this point, you have a manageable monthly payment at a lower interest rate than your charge cards. There are two types of debt consolidation loans: secured and unsecured.

Secured Loan

A secured debt consolidation loan has some sort of collateral associated with it. Collateral can be anything of value, that is at least the value of the loan. Examples of collateral are: a home, a car, boat or fine jewelery. The majority of consolidation loans are secured.

The point of a secured loan is that the lender gets the asset if the borrower defaults on repayment of the loan. That is, the borrower takes the risk. The borrower is risking the collateral asset used as security. So, if the borrower is using their car for collateral, and the borrower cannot repay the loan, then the lender seizes the asset.

The risk to the lender, on the other hand, is almost non-existent. Since the loan is backed by an asset that is equal to, or exceeds the value of the loan, the lender can offer a lower interest rate than on an otherwise unsecured loan.

Unsecured Loan

The other type of debt consolidation loan is unsecured. This type of loan is much more infrequent and more difficult to obtain due to the fact that risk lies entirely with the lender an not with the borrower:

An unsecured loan uses no collateral, and is "secured" solely on the basis of the borrowers good credit. In the event that borrower can no longer continue paying off the loan and is forced into liquidation and bankruptcy, the lender will likely lose most, if not all, of their investment. Because of the high risk involved, unsecured debt consolidation loans carry a higher interest rate

Still the ultimate risk is to the borrower. If the borrower defaults on an unsecured loan, it is almost impossible to get another one.

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