A debt consolidation loan could be a smart way to save money. Here's what you need to know about how some of our best debt consolidation loans work, and whether they're a good idea to consider for stabilizing your finances.
What Is Debt Consolidation?
Debt consolidation combines two or more debts into one, typically with new financing terms and often a different lender. This new lender pays off your existing debt and charges you a lower interest rate than you currently pay. Most consumers choose debt consolidation to lower interest rates and save money.
For instance, consider the scenario below: a person has $9,000 in credit card debt spread over two cards with interest rates of 24.99% for the larger balance ($7K) and 17.99% for the smaller ($2K). They are paying $200/month to each.
| Credit Card #1 | Credit Card #2 | Debt Consolidation Loan |
|---|---|---|
Balance: $7,000 APR: 24.99% Monthly payment: $200 Payoff time: 64 months Total paid: $12,734.44 Total interest: $5,734.44 | Balance: $2,000 APR: 17.99% Monthly payment: $200 Payoff time: 11 months Total paid: $2,184.36 Total interest: $184.36 | Balance: $9,000 APR: 13.99% Monthly payment: $400 Payoff time: 27 months Total paid: $10,542.61 Total interest: $1,542.61 |
Consolidating these debts at 13.99% APR with the same monthly payment of $400 saves the debtor nearly $4,400 in interest payments and reduces the time it takes to pay off the debts to just over three years.
How Does Debt Consolidation Work?
Debt consolidation allows you to combine various debts into one easy payment. It can reduce the interest rates you pay on each individual debt and help pay off your balances faster. Paying off your debt consolidation loan on time each month and in full can bolster your credit score.
There are a few different products that offer a route to credit consolidation:
Personal loans
These loans are unsecured, so you don't need to use collateral like your car or home. Personal loan amounts usually range from $1,000 to $100,000, with repayment terms starting at two years. Some lenders offer lower rates if they pay off your existing loan or credit card balances directly.
Home equity loans
“If you own your house, then using a home equity line of credit or home equity term loan is the best possible debt consolidation loan,” says financial planner Tyler Owczarski of Fiduciary Financial Advisors. “This is usually the lowest interest rate for a consolidation loan.”
Home equity loans use your home’s equity as collateral. Depending on the lender, you can usually borrow 80% to 90% of your home’s total equity. Repayment terms typically range from five to 30 years, which is longer than most personal loans. While home equity loans offer lower interest rates, you risk losing your home if you default.
Balance Transfer Offers
Transferring your existing credit card balance to one with an introductory balance transfer offer can help you save on interest payments. These offers typically feature a 0% APR for a limited time, usually between six and 21 months. During this period, you won’t pay interest on your balance, so your payments go directly toward reducing your principal.
While this is a great way to manage your credit card debt, most of these offers include a balance transfer fee, typically 5-10% of the total amount being transferred.
Is Debt Consolidation a Good Idea?
If you're juggling multiple debts and feeling overwhelmed, debt consolidation can offer relief, especially if you can secure a lower interest rate than you're currently paying.
The effectiveness of debt consolidation depends on factors like the interest rates of your current debts, the consolidation loan terms, and your ability to make consistent payments. If you can secure a consolidation loan with a lower interest rate and a similar payoff schedule, you may see long-term savings. Additionally, extending the repayment period can make monthly payments more manageable.
However, debt consolidation isn't a one-size-fits-all solution. If you have a small balance that you can pay off quickly or if your debt issues stem from poor spending habits, consolidation may not be the right choice. In such cases, focusing on budgeting and financial planning might be more effective in addressing the root causes of your debt.
Pros of Debt Consolidation
Consolidating your debt can offer benefits that include saving you money, untangling your finances, and improving your credit:
Interest savings. Consolidating to a lower interest rate can save you hundreds or even thousands of dollars, depending on your current loan terms and the consolidation loan terms.
Lower monthly payments. A lower interest rate usually means lower monthly payments, freeing up more money in your budget. You can use these savings to pay off your loan early, tackle another debt, or save for the future.
Simplified payments. Consolidating multiple loans into one simplifies your finances by reducing the number of payments you need to manage. With just one payment to worry about, you can better organize your budget and reduce the risk of missing a payment.
Improved credit scores. Lower monthly payments from consolidation can reduce your debt-to-income ratio, a key factor in calculating your credit score. And an improved credit score can make it easier to qualify for future loans, like a mortgage.
Cons of Debt Consolidation
Debt consolidation loans can be a useful tool for getting control of your finances, but they’re not for everyone. Here are some reasons why you might want to steer clear of debt consolidation:
Higher interest rates. If your credit score is below average, you may not qualify for a lower interest rate, potentially resulting in higher overall costs.
Upfront Costs. Many debt consolidation loans come with fees such as origination fees, balance transfer fees, and closing costs. These can add to the overall cost of the loan and reduce the savings you can expect from a lower interest rate.
Risk of increased debt. Consolidating debt doesn’t address the underlying issues that caused the debt in the first place. Without disciplined financial habits, you might accumulate new debt on top of the consolidation loan, exacerbating your financial situation.
Secured vs. unsecured Loans. If you consolidate via a secured loan, like a home equity loan, you risk losing your collateral if you default on the loan. Unsecured loans, however, might have higher interest rates due to the lack of collateral.
Impact on credit score: Applying for a consolidation loan can temporarily lower your credit score due to hard credit inquiries. Additionally, if you fail to make payments, your credit score could suffer further.
Many reputable debt consolidation companies offer a free consultation where issues like these can be addressed.
Our Top 3 Debt Consolidation Loan Providers
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When Should I Consolidate My Debt?
Consider consolidating your debt when you can secure a lower interest rate than you are currently paying. This can help you save money and make your monthly payments more manageable. Additionally, consolidating can simplify these into a single payment if you have multiple debts with different due dates and payment amounts.
Another factor to consider is consistent income. If you don't have a steady income to meet the new monthly payment terms without accruing additional debt, now is likely not the time to consider debt consolidation.
How To Get a Debt Consolidation Loan
If you've decided that credit consolidation is the right step for your financial future, here are five important steps to follow:
1. Review Your Credit Score
Understanding your credit scores is crucial, as lenders will use them to assess your eligibility and determine your loan's terms. Knowing where you stand on the credit scoring spectrum is essential, as it influences the interest rates you may receive.
Debtors with credit scores of 700 or more have higher chances of loan approval with a favorable and competitive interest rate. Those with scores below 700 can still successfully apply for a consolidation loan but expect a higher APR.
2. Itemize Your Debts and Payments
Make a list of all the debts you want to consolidate. These could include credit cards, payday loans, and personal loans. Add these up — this is the amount you'll want your debt consolidation loan to cover.
Next, tally up the amount you pay each month toward those same debts. Weigh this number against your budget to determine if you can pay more while still keeping your head above water.
You'll want to have these figures ready when you reach out to credit consolidation companies.
3. Compare Consolidation Loan Options
Next, compare multiple loan offers to secure the best terms:
Look at reputable review sites such as the Better Business Bureau and TrustPilot for consumer feedback.
Explore various lenders, including banks, credit unions, and online marketplaces.
Look for a company that offers features such as direct creditor payment, discounts with autopay, and free financial resources that you can access in the future.
Most reputable debt consolidation companies will offer a free consultation. Be sure to ask about origination fees and prepayment penalties, which can add significant costs.
4. Apply for a Loan
Once you've chosen a suitable loan offer, complete the application process. Be prepared to provide personal, employment, and income details, along with supporting documents that can include a government ID, pay stubs, bank statements, and proof of residence. Expect a hard inquiry on your credit report as part of the lender's assessment.
5. Finalize the Loan
Upon approval, the lender will disburse funds either directly to creditors or to your bank account.
If funds go to creditors, continue making payments until accounts are verified as paid off (usually around a month). If funds are deposited to your account, promptly use them to settle outstanding debts. Moving forward, make consistent, timely payments on your new loan to establish a positive payment history.
Bottom Line
Debt consolidation can effectively manage multiple debts and reduce overall interest payments, especially if you're struggling to meet monthly obligations. With debt consolidation, you can save money and simplify your financial management.
However, evaluating your financial situation, understanding the consolidation loan terms, and committing to disciplined repayment is crucial to avoid falling back into debt. With careful planning and informed decisions, debt consolidation can help you regain control of your finances and work towards a debt-free future.
