Consolidating Unsecured Debt with Secured Loan

Question

So long story short, I've got about $20,000 in unsecured debt between a personal loan of $15,000($14,000 remaining principle) with the rest spread between three credit cards. I initially got the personal loan with the intention of buying a car while also paying down my credit card debt to lower my utilization. I ended up spending a bit more than I hoped on a car and didn't have enough to eliminate all of the credit card debt. On top of that, AmEx lowered my credit limit substantially after I paid the bulk of that card off. As such, my utilization is around 85% when it would've been more around 40%.

Now a few months later, I've been considering getting a secured loan with my car as collateral for the full amount of my debt to consolidate into a single payment. Currently, the interest rate on all of the current debt is between 20% and 24%. I've spoken with my loan company and there would be a small amount of interest required(~$100) with the payoff amount and no other fees or penalties. I haven't yet applied for any loans, but I've seen secured loans for the amount I need with interest rates between 9% and 14%.

Current loan: $15,000 principle, 22% interest, 48 month term, $477 monthly payment

Credit card debt: $6,500 total, 21%-24% interest, ~$200 monthly minimum payments

New loan: $23,000 principle, 9%-14% interest, 60 month term, $485 - $540 monthly payment

To the amateur financial mind, this seems to make total sense. Lower payment, lower interest rate, lower credit utilization, and raise credit score.

So my question is -- does it make sense to consolidate into a secured loan at a much better interest rate? Are there any major reasons to be wary of opening up a secured loan in this way?

Answer 1

Assuming that your car is worth significantly more than $23k (otherwise you'll be underwater soon), and your income is more than double the value of the car (a rule of thumb as to whether a car is affordable), this is okay, so long as you don't take on any more debt. It's easy to feel like you got a "raise" when you lower your debt payment, and to start spending more money, taking on more debt, and wind up being worse off than you were before. You're already showing that tendency by borrowing more than you need to pay off the unsecured loans.

A better plan would be to pay down the debt as much as possible, and get as short a loan term as you can afford (do you want to be paying for this car for the next 5 years?)

The biggest drawback to this plan is for some reason you can't make the payments, your car could get repossessed. At least now all they can do is take you to court to get a judgment. You might also be required to get more insurance on the car if you don't have enough now. However, if those are significant concerns, it probably means you can't afford the car anyways.

A more radical plan would be to sell the car, pay off all (or most) of the debt, buy a cheaper car with cash, and start saving the debt payment to buy your next car with cash in a year or two. Then you're not wasting your money on interest payments.

I would ignore the impact to your credit score altogether. So long as you don't miss payments and don't overuse credit, your score will be fine.

Answer 2

The numbers look good. I just did something similar myself: I recently married and my wife had a bunch of debts, including a $14,000 loan at 14%. I took out a home equity loan with an introductory rate of 3.5% for the first year, then going to 9% and used that to effectively refinance the the $14,000. I figured the first year that would save us over 10% in interest, or $1,400, and even after that it was saving 5%.

There are two catches to your plan.

1. A secured loan has a lower interest rate because if you fail to make payments, the bank can repossess your car. With the unsecured loan, mostly they could ruin your credit rating. So if you think it's a realistic possibility that you might not be able to make the payments, that's something to consider.

2. There's a potential psychological factor. You pay off several debts, you have a lower payment ... and now you start thinking that you have room to run up some new debt. If you do consolidate like this, I'd say: Don't don't don't get complacent and run up new debt.

Before I married a bunch of debt, the only money I owed was my mortgage, and I had been making extra payments to pay this off. I'm sure I could easily qualify for a big car loan but instead I'm driving a 2003 pick-up that I bought used for $5,000. My mortgage payment is 7% of my take home pay. Get out of the habit of borrowing money to buy what you want, and instead save to buy so that you are collecting interest rather than paying it. Make borrowing the unusual, special case.