Debt consolidation allows you to simplify your financial life by combining a number of bills into a single monthly payment. With a debt consolidation loan, you take out an unsecured personal loan and use the funds to pay off existing debt. As long as you can qualify for a low interest rate, this can be a faster, easier, more cost-effective way to get out of debt.
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Benefits of consolidation loans
A consolidation loan is not the only type of financing you can use to pay off debt. However, in the right circumstances, it can provide the widest range of benefits.
No juggling bills and you know what to expect
Like any form of consolidation, the biggest benefit of a consolidation loan is that you only have one payment to worry about. You go from juggling multiple bills for your credit cards and other debts each month to just one due date.
What’s more, the payments on a loan are fixed. You know exactly how much money you’ll need to cover the payment in your budget each month. This can be beneficial versus credit cards, where the payments can change.
You’re not risking your home or assets to consolidate
Other financing options that consolidate debt require you to borrow against something. You’re not borrowing against your home, your 401(k), or your life insurance policy. This means that you’re not forced to put yourself into a riskier financial position just to get out of debt.
You can save money as you get out of debt
Consolidation loans have a fixed interest rate that’s locked in when you take out the loan. If you have good credit, it can be significantly lower than the rates on your credit cards. What’s more, the rate won’t change (which can happen with credit cards and other adjustable-rate lending products).
Interest rates on loans are based on the prime lending rate set by the Federal Reserve and your credit score. Currently, the prime rate is low – close to zero – meaning that you can consolidate at a low rate. With excellent credit, you could enjoy rates of less than 10% APR.
Get off the credit card payment treadmill
By definition, a loan has a set date when your payments start and a set debt when your payments will end. So, you can know the exact date that you will be debt-free. You get off the credit card debt treadmill where you diligently make payments, but your balances never seem to go down.
Find a loan that fits your credit and your needs.
How do consolidation loans work?
Step 1: Get ready to apply
Before you apply for a consolidation loan, you should have a grasp of how much you need to borrow.
You also need an idea of what interest rate you need for the loan to be beneficial. Ideally, you want the interest rate to be at least half of the average APR that you have on your credit cards.
Debt.com has a worksheet that can help you total up your balances and assess your current APR. This will help you get ready to begin shopping for loans.
Based on how much you owe, you can also use a loan calculator to estimate the monthly payments you can expect and the term you will want on the loan.
You should also gather up documentation that will verify your identity, address, and income with the lender.
Step 2: Shop for the best loan
It’s always a good idea to get multiple quotes for loans before you choose one. Lenders can offer different rates, terms, fees, and incentives, such as giving you a rate discount if you use AutoPay.
You want to find the rate with the lowest interest rate and fees, the most flexible terms that fit your needs. Only then should you apply.
Good places to look for quotes:
- Your own bank or credit union
- Other credit unions, which often offer lower rates than banks if you have good credit
- Use a loan comparison tool that will show you quotes from multiple online lenders at once
Make sure while shopping that you specify that you are only seeking a quote.
If you apply for a loan, it will create a credit inquiry on your credit report that will decrease your credit score by a few points. If you apply for several loans at once, it can damage your credit, even if you only end up taking one loan.
Step 3: Apply for the loan and get approved
Once you find a loan that fits your needs, you can apply for it through that lender. Your application will be given to a loan underwriter who will approve your application and work with you to finalize the loan.
The underwriter will ask for all the documentation that you gathered in Step 1. Having it ready will ensure your loan gets processed as quickly as possible. You can usually fax or deliver the documentation through a secure electronic method (it should never be emailed).
The underwriter will ask you to authorize a credit check so they can check your credit. You must have a minimum credit score to qualify. The minimum score required varies by lender.
They will also run your debt-to-income ratio to make sure you can afford the payments. The calculation they do will include the new loan payments but not include all of the debts you wish to pay off. Most lenders require a DTI of 45% or less to qualify.
Once you’re approved, you and the underwriter will also determine how the funds from the loan will be disbursed.
- In some cases, the lender may agree to deposit the money into your bank account. Then you would need to divvy up the funds to pay off your credit cards and other debts.
- In others (specifically if you have a lot of debt and your DTI is high), the lender may require that they send the funds directly to your creditors. This ensures the money gets used to pay off your debt.
Step 4: Pay the loan off, check your credit
Once the funds from the loan have been sent to your creditors, it will zero out all of your credit card balances and pay off your other obligations.
This should leave only the debt consolidation loan and any loans you didn’t consolidate, such as secured loans and federal student loans, to pay off. It should be much easier to manage your bills each month and avoid missed payments.
It’s a good idea to check your credit reports to make sure all of the balances on the account you pay reflect the payoff. Installment loans and collection accounts should be listed as paid in full.
Assuming you keep your credit cards open, the accounts should show a current status with a zero balance.
You can either check your credit reports for free or you can use a credit monitoring tool to monitor the accounts and the impact consolidation had on your credit score.
What you can and can’t consolidate with a loan
Debt consolidation loans can be used to consolidate more than just credit card debt, although that’s the most common purpose. This includes:
- General purpose credit cards
- Gas cards
- Store credit cards
- Medical credit cards
In addition, there are a number of other debts and obligations you may consider consolidating:
- Medical bills or medical collections
- Other third-party collection accounts
- Back taxes
- Back child support or alimony
- Other personal loans
- Debt consolidation loans (yes, you can re-consolidate)
- In-store credit lines for purchases such as furniture or electronics
However, not every debt can be consolidated into one loan.
- Any loan that is secured with collateral, such as your mortgage and auto loan, can’t be consolidated with an unsecured loan.
- Many lenders will not allow student loans to be consolidated with other types of debt. However some lenders will and other will only consolidate private loans. It just depends on who you work with.
Best practices when applying for a consolidation loan
Avoid loans with lots of fees
It’s normal for a loan to have an origination fee, where you pay 1-5% of the amount you borrow. However, some lenders tack on lots of other fess, including early repayment or prepayment fees that penalize you if you try to pay the loan off faster that scheduled.
Read the fine print before you sign
A lender must provide a disclosure that outlines all the fees, interest rate, number of payments and other terms of your loan. This disclosure is required by federal law under the Truth in Lending Act (TILA).
If you don’t receive this disclosure don’t sign the loan agreement! You could be dealing with a predatory lender that’s trying to rip you off.
If you do receive this disclosure, read it carefully, and make sure you understand all of the terms of the loan. Ask questions if you have. Don’t sign the loan agreement until you know fully what you’re signing up for.
A short term helps you save money overall
As you apply for a loan, you will get to choose a term, usually anywhere from 12 to 60 months. Choosing the longest term possible will lower the monthly payment. You could enjoy a much lower payment than the total payments you must cover before you consolidate.
However, a longer term means more months for the lender to apply interest charges. In other words, you increase the cost of getting out of debt.
You want to choose the shortest term that offers monthly payments you can afford. This will help you save money as you get out of debt. It also ensures you can really become debt-free.
If you’re living paycheck-to-paycheck, you could make your situation worse
Consolidation loans are great and can work wonders if you have breathing room in your budget. If you can afford the loan payments, put money in emergency savings, and still have cash flow leftover, then consolidation may be the way to go.
On the other hand, if you can barely afford the payments and don’t have any emergency savings, the loan may be unlikely to help. In fact, you could make your situation worse. You will run up new credit card balances and be right back to juggling bills.
Consolidation loan FAQ
Q:Can I consolidate a debt consolidation loan?
However, consider carefully if you’re really in a position to become debt-free with the new loan. You want to avoid just kicking the financial hardship can down the road.
Q:Will consolidating close my credit cards?
However, there may be some circumstances where a specific lender might require you to close your credit cards. This usually happens if they see if your credit profile that you have a habit of consolidating and then running up new balances.
That would make you a risk for a lender, in which case they may make your loan approval contingent on closing your cards.
Q:How will debt consolidation affect my credit?
It will drop your credit utilization ratio to zero, which is great for your score (as long as you avoid new balances. You will have an easier time making your payments, so you avoid missed payments in your credit history that can happen when you juggle bills
As long as you only apply for one loan as you shop around, you won’t damage your credit with too many inquiries at once. Avoid other new credit applications for about six months to ensure you avoid unintentional score damage.
Of course, failing to pay back the loan on time and missing payments or running up new credit card balances can hurt your score.
What’s more, newer scoring models such as FICO 10 look at borrowing trends in your credit. Debt consolidation loans may indicate a potential issue, particularly if you consolidate and then reconsolidate.
But as long as you make the payments on time and don’t go right back into debt, The results for your credit should be positive.
Alternatives to consolidation loans
An unsecured personal loan is not the only financing tool you can use to combine multiple debts into one payment.
Options that require new financing
If your credit is relatively good or you have equity you might consider these options. But, beware there are some drawbacks to be carful of.
- A balance transfer credit card is specifically meant to consolidate credit card debt from your existing accounts. It can work if you owe a limited amount of credit card debt.
- If you have a retirement account, such as a 401(k), then you may be able to use a 401(k) loan. This borrows against the money you have saved. However, this can be risky. For instance, if you lose your job or quit, the loan becomes immediately due in full.
- If you have a whole life insurance policy, you can borrow money against the policy’s cash value. Interest rates tend to be low and there’s often not even a set repayment schedule. However, if you die, the balance on the loan will be deducted from the benefits your loved ones will receive.
- Homeowners have a range of options for borrowing against their home equity (the home’s value minus the remaining mortgage balance). These include a home equity loan, Home Equity Line of Credit (HELOC), or cash-out refinance
Borrowing against your equity can be beneficial because you can get a lower interest rate even with a weaker credit score. However, at the same time, you’re taking on more risk. Using your home as collateral to secure a loan means your home can be taken if you fail to pay.
Options that don’t require new financing
New debt may not always be the best solution for solving challenges with existing debt. If you owe more than $50,000 or you have a bad credit score, you may not qualify for a consolidation loan. Even if you can qualify, it may not be the best option depending on your situation.
You may want to consider other options if:
- You’re living paycheck to paycheck
- You have no money in your savings
- You’ve consolidated previously and are still facing challenges
- Your credit score is low
- You feel like your financial control is slipping away
In these cases, you may be better off with other debt relief options.
- Debt management program is a professional assisted repayment plan. Like consolidation, it gives you one monthly payment and minimizes interest charges. But you don’t get a new loan. Instead, a credit counseling agency helps you set up a plan that pays back everything you owe in a more efficient way.
- Debt settlement is a program that works best for people who simply want a faster, cheaper exit from debt and aren’t worried about their credit score. You get out of debt for less than the full amount you owe.
- Bankruptcy may be your best solution in some cases if you just need to get a clean slate with your debt and start over. In this case, bankruptcy may be the way to go. It can help you stop a cycle of trying solutions that end up not working. Usually, people who are looking at consolidation loans aren’t ready to consider bankruptcy. But it’s important to be realistic about your situation.
Talk to a trained debt relief specialist to review your options for free.
Article last modified on March 31, 2023. Published by Debt.com, LLC