How Debt Consolidation Loans Work
If you have a pile of debt, even if you manage to pay your bills every month, you might feel like you’re not getting ahead of what you owe. This is when debt consolidation can help.
Debt consolidation is the process of consolidating multiple debts into one loan with a monthly payment and a (hopefully lower) interest rate. It can help you stay organized and potentially save money.
What is a debt consolidation loan?
A debt consolidation loan is one way to refinance your debt. You will apply for a loan for the amount you owe on your existing debts, and once approved, you will use the funds to pay off your outstanding debts. Then you will pay off the new loan over time.
When choosing a debt consolidation loan, you will need to assess a few different characteristics:
- Type of loan: The most common types of loans include personal loans, credit cards with 0% introductory APR, 401 (k) loans, and home equity loans.
- Loan conditions : The loan amount, the interest rate, and the length of the loan depend on the type of loan you get and your financial health.
- Secure vs. Unsecured: With a secured loan, you have to put down collateral. For example, a home equity loan is secured by your home. If you fall behind in payments, the lender can take this collateral to satisfy your outstanding balance. If you don’t want to risk your assets, consider sticking with your unsecured options, such as personal loans and zero-interest credit cards.
How Does a Debt Consolidation Loan Work?
Most debt consolidation loans are fixed rate installment loans, which means the interest rate never changes and you make a predictable payment every month. So if you have three credit cards with different interest rates and minimum payments, you can use a debt consolidation loan to pay off those credit cards, leaving you with just one monthly payment to manage instead of three.
Let’s say you are paying off credit card debt. Here’s how a debt consolidation loan can help you save on interest charges:
- Card 1 has a balance of $ 5,000 with an APR of 20%.
- Card 2 has a balance of $ 2,000 with an APR of 25%.
- Card 3 has a balance of $ 1,000 with an APR of 16%.
If you pay off those credit card balances over 12 months, your interest charge would be $ 927. But let’s say you take out a 12 month personal loan for the amount you owe – $ 8,000 – with an APR of 10%. If you pay off the loan in one year, you reduce the interest charge to just $ 440. To calculate the savings on your own debt, try using a credit card repayment calculator and a personal loan calculator.
Benefits of a debt consolidation loan
If you’re looking to save money, streamline your monthly payments, and circle the repayment date on your calendar, debt consolidation may be right for you. Here is an overview of the main advantages:
- Pay off your debts faster. Making the minimum payment on your credit cards can stretch your repayment schedule for years. A debt consolidation loan can help you pay off faster.
- Save on interest charges. Generally, if you qualify for a lower rate than what you are currently paying, you will save money on interest charges. At the end of October 2020, the average credit card interest rate was 16.02%, while the average personal loan rate was 11.88%.
- Simplify your monthly payments. It’s easier to manage a single monthly payment than multiple payments with different due dates. This reduces your chances of missing payments, which is good for your credit.
- Repay on a fixed schedule. Many debt consolidation loans are fixed payment loans, which means that you will know exactly when you are debt free. It can help motivate you while you pay off your debt.
Risks of a Debt Consolidation Loan
You will need to weigh your immediate needs against your long term goals before moving forward. Some people choose to consolidate debt to save money and organize their monthly payments, but there are downsides to consider.
- It won’t solve all of your financial problems. Once you use the debt consolidation loan to pay off your debt, you might be tempted to start using your credit cards again. This increases your overall debt, which can impact your credit and make it harder to pay off your balances.
- There may be an upfront charge. Some debt consolidation loans come with fees, including origination fees, balance transfer fees, prepayment penalties, annual fees, and more. Before taking out the loan, ask the lender if any of these conditions apply.
- You can pay more interest. This can happen in two ways. Depending on your credit rating, your debt-to-income ratio, and the amount of your loan, you may be paying a higher interest rate than on the original debt. Or, if you use the debt consolidation loan to lower your monthly payments by lengthening your repayment term, you could end up paying more interest in the long run.
Understanding Debt Consolidation Loan Interest Rates
When you pay off a debt consolidation loan, you are not only paying back the amount you borrowed, you are also paying an additional amount each month in the form of interest. The interest rates on debt consolidation loans generally range from 5.99% to 35.99%. A higher interest rate will cost you more over the life of the loan than a lower interest rate. Each lender has different criteria for setting rates, so shopping around can help you find the best deal.
Typically, lenders check these factors when deciding if you qualify and setting your interest rate:
- Your credit rating: Borrowers typically need a credit score in their mid-600s to qualify for a debt consolidation loan, and a higher score can help you get a lower interest rate.
- Your DTI ratio: Your debt-to-income ratio (DTI) tells lenders how much of your monthly income is spent on debt repayment. Lenders tend to look for a lower DTI ratio.
- Returned: The lender will verify your employment and verify that you are earning enough to make payments.
If you don’t quite qualify for credit, you may be able to find a lender willing to give you a loan, although you may get a higher interest rate. If you are in this situation, consider adding a co-signer to the loan. This person promises to take over the payments if you fall behind – so they need to understand what that entails before they say yes.
How to Apply for a Debt Consolidation Loan
There is a bit of work to be done, but it will pay off if a debt consolidation loan saves you money. Start by withdrawing your credit, comparing quotes between multiple lenders, and checking your odds of loan approval.
- Understand your finances. A good credit score gives you a better chance of qualifying for a debt consolidation loan and getting a good interest rate. Check your credit score before you apply to see if it needs work.
- Compare the terms of the lender. Seeking out the best deal can help you save money on debt consolidation. Get quotes from multiple lenders and compare interest rate, fees, loan term, and monthly payment.
- Get prequalified. Some lenders offer prequalification, which gives you an overview of the type of offers you might receive. Many can only do soft credit, which means prequalifying won’t affect your credit score.
- Gather what you need to apply. When applying for a debt consolidation loan, you may need your social security number and contact information, an estimate of your monthly debts, a pay stub, and employer information for prove your income.
Once you are approved, the lender can pay the proceeds of your loan to your creditors or send the funds to you. Make sure the original debt is paid off, then get to work on your new loan. Set up automatic payments or use reminders to make payments on time each month. Over time, you will be debt free.