Published in: Personal Loans | Dec. 5, 2019

Don't Use These 4 Loan Types for Debt Consolidation

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Debt consolidation loans can often make debt repayment easier, but these four types of consolidation loans could make your financial situation much worse. 

Debt consolidation is, in many cases, a smart financial move. If you can get a consolidation loan that allows you to simplify the repayment process, it may seem like a no brainer that you should say yes to borrowing.

But the reality is that not all debt consolidation loans are good ones. In fact, there are four specific kinds of loans you should usually avoid when you're consolidating your debt. 

Someone signing loan paperwork and being handed money.

Image source: Getty Images

1. High interest loans

The goal of debt consolidation shouldn't just be to go from having many loans to having one. You should also make sure you lower the interest rate on your debt when you consolidate. Otherwise, you're just making payoff more expensive. 

Always compare the rate on the consolidation loan you're being offered with the rate you're paying on your current debt. If the rate is the same or below, then you should be good to go. But if the consolidation loan raises the rate, walk away. 

Repayment can also become more costly if you lower the interest rate but also stretch out the time it takes to pay off your debt. Some consolidation loans simply make payoff appear more affordable with a lower monthly payment, but since you will be paying the loan for longer, it will cost you more in the long run.

2. Loans with high fees

It's not just a higher interest rate that could make a debt consolidation loan too costly to be worth it. High loan fees also make the cost of debt payoff more expensive and may mean consolidation isn't a good idea.  

Unfortunately, some unscrupulous lenders target people looking for consolidation loans and offer them financing that seems good on the surface but that comes with high fees. These fees could be origination or application fees. Or you may find the new loan has hefty prepayment penalties that will prevent you from paying off the loan ahead of schedule. 

Always look at the fine print with any loan offer to see exactly what fees you're being charged. If the fees negate any savings you'd get from consolidating, you're better off keeping your debt with your current creditors and avoiding these added costs. 

3. 401(k) loans

At first glance, borrowing from your 401(k) to repay debt could seem like a great idea. After all, you are borrowing from yourself and paying interest to yourself.

However, if you don't pay back the loan on time, that's where the problem comes as there could be serious consequences. You could be taxed on the money you withdrew and hit with a 10% penalty if you weren't yet 59 1/2 when you took the money out.

You don't only risk these big penalties by failing to follow your payment schedule, but also if your repayment obligations are accelerated because you have to leave your job. If you end up leaving your employer -- either voluntarily or involuntarily -- while you have a 401(k) loan, the borrowed funds have to be paid back by tax day. So if you can't pay back the loan by the due date of the tax return for the year you've left your job, you'll be hit with these big penalties.

Unfortunately even if you do pay back your loan, by pulling your money out of your investments during the repayment process you could jeopardize your retirement savings as you'd miss out on market gains that would've otherwise resulted. 

4. Loans guaranteed by the equity in your home

Home equity loans, home equity lines of credit, and mortgage refinance loans can also serve as a source of financing to consolidate your debt. But just because you can borrow against your home to pay off what you owe doesn't mean you should -- even though it may be tempting to do so because loans guaranteed by your home often charge a low interest rate.

The problem is, in most cases, the debt you're paying off with a consolidation loan is unsecured debt. But when you take out a loan against your home, you're switching it to a secured loan. All of a sudden, your house is at risk of foreclosure if you can't pay back what you owe -- and that's a big risk to take. 

Stripping the equity out of your home could also leave you owing more than the home is worth and trap you in the house until the debt is paid down. This could become a big problem if you need to downsize or move. 

Be smart about the debt consolidation loan you take out

While these four types of loans aren't good for consolidating debt, there are other loans out there that could be great for helping you reduce your interest rate and make debt payoff easier and more affordable. Consider looking into a personal loan or balance transfer if you're interested in debt consolidation so you can find the financing that's right for you.

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