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What is a debt consolidation loan?
Debt consolidation refers to the process of combining multiple debts in a single monthly payment. A debt consolidation loan is a personal loan that you take out for that purpose. The funds from the loan are used to pay off credit cards and other unsecured debts. This leaves only the low-interest loan to repay. Consolidation typically makes it easier to get out of debt faster, because it allows you to focus paying off the principal, rather wasting money on accrued monthly interest charges.
|Debt Consolidation Loan|
|Type of debt||Unsecured|
|Payments||Fixed (the same throughout the life of the loan)|
|Interest||Low APR compared to high interest rate credit cards|
|Approval||Based on your credit score and debt-to-income ratio|
|Term||Varies based on the monthly payment you can afford; recommended 5 years (60 payments) or less|
|Use to pay off|
How can I get a debt consolidation loan?
You apply for a debt consolidation loan the same way you would for any other financing.
- Simply go to your bank, credit union or preferred lender; you can also use online lending services.
- Fill out an application, requesting an amount that covers the total amount of debt you wish to pay off.
- Choose a term for the loan, based on the monthly payments you can afford to make
- A longer term offers lower payments, but higher total costs
- A shorter term reduces total costs, but increases the monthly payment requirement
- After you submit your application, you work with a loan underwriter to get your approval.
- They review your credit score to see if you qualify and to determine the interest rate
- Then they check your debt-to-income ratio to ensure you can afford the payments (more on DTI and loan approval below)
- Finally, they get a list of all the debts you wish to pay off with the loan.
- Once you receive approval, the funds are disbursed to pay off your creditors. This eliminates your credit card balances and leaves only the loan to repay.
How hard is it to get a debt consolidation loan?
Approval for a debt consolidation loan depends on two factors:
- Your credit score
- Your debt-to-income ratio
The lender reviews your credit to see if you qualify. Better credit also allows you to qualify for a lower interest rate. That matters, because you want to secure the lowest rate possible when you consolidate. So, the better your credit, the more effective a consolidation loan can be.
Debt-to-income (DTI) ratio comes into play because the underwriter must ensure you can afford the payments on the loan. Lenders always check your DTI when you apply for a loan, whether it’s a mortgage or a personal loan. They divide your total monthly debt payments by your total monthly income. In order to qualify, your debt-to-income ratio must be below 41 percent with the new loan payments included.
When it comes to getting approved for consolidation, there’s a special consideration. You usually apply for a consolidation loan because you have too much debt. So, chances are high that your DTI will be over 41 percent with the new loan payments plus your existing credit card payments.
However, the lender will also check what your DTI will be once you pay those accounts off. If that ratio is below 41 percent, then you can get approved, but only with direct disbursement.
What is direct loan disbursement?
Disbursement is a delivery of funds from a loan. The lender pays money out and someone receives it. Direct disbursement on a consolidation loan means the funds are delivered directly to your creditors instead of you.
Basically, if your DTI is only below 41 percent once your credit card accounts are paid off, the lender will only approve the loan with the stipulation that they send the funds directly to your creditors. That way, they know for certain that the accounts will be paid.
If the lender requires direct disbursement, they will send payments to each of your creditors for the balance listed when you applied for the loan. If you made a payment between when you applied and the disbursal, this may mean you get a credit on that account balance. Addressing account credits is one of the things you should do after you consolidate.
If the lender does not require direct disbursement, then they will deliver the funds to you, usually through Direct Deposit. In this case, it’s up to you to then use the money to pay off your credit card accounts.
3 Things to Know Once You Consolidate Debt with a Personal Loan
#1: You can end up with account credits
If the lender requires direct disbursement, they will send a lump-sum payment to each of your creditors. The amount for each disbursal equals the balance listed for that account when you applied for the consolidation loan. However, if you made a payment between when you applied for the loan and when disbursement occurs, your balance may be lower.
If this happens you will get account credits. You can either ask for a refund and they’ll cut you a check or you can leave it be to cover new charges on the account. If you plan to use the card once you zero out the balance, go for the latter to reduce your next bill.
Of course, you can have the opposite happen to your account, too. If you make new charges between when you apply and disbursement, you could have a balance to pay in the next billing cycle. Just make sure to check your account balances after disbursement to see where each account stands after you consolidate.
#2: The creditor may still apply interest charges within that billing cycle
Unless you time things correctly to match up disbursement to your payment due dates, you may pay off your balances in the middle of a billing cycle. If this occurs, although you might expect that you won’t have a balance to pay that cycle, you may end up with a small bill to cover accrued interest charges for the month.
This happens due to how creditors apply interest charges. Most creditors calculate interest charges based on your average daily balance for the billing cycle. That’s basically your balance averaged out over the number of days in that payment cycle. If you pay off your balance in the middle of a cycle, it means that interest charges still apply; they just apply only for the number of days that you carried a balance.
If you receive a bill for interest charges after you pay off the balance, call the creditor. In many cases, they may be willing to waive those interest charges as a reward for paying off your balance. Remember, your creditors want you to keep using their cards. So, they’re usually willing to work with you, especially if you took steps to keep your account in good standing.
If the lender disburses the funds directly to you, you can avoid this by paying the balance off on your payment due date. That way, you start the next cycle with a zero balance. That’s beneficial because it means that you can make new charges interest-free in the next billing cycle. Just pay off the new charges in full and interest charges won’t apply.
#3: Zero balances on your credit cards can be trouble
If you’re like most people, you probably made an effort to stop charging in the run up to consolidation. You see your debt levels rising, so you curtail your spending to slow it down. You resist the urge to pull out the plastic anytime you see a good deal or something you need.
Now however, after you consolidate with a personal loan, your credit card balances all go back down to zero. It can be really tempting to start making new charges again. You have things to buy, rewards to earn and vacations to take. But this can be a recipe for financial disaster.
If you run up new balances too quickly, then essentially consolidation increased your debt instead of decreasing it. You have new credit card balances to pay, plus the debt consolidation loan payments. You’ve created more of a debt burden on your budget when your goal was to reduce the burden.
So, using a debt consolidation loan means you need to have willpower to continue curtailing credit card purchases. You must resist the urge to charge, ideally until you have the loan completely paid off. At the very least, just make sure debt payments don’t use up more than 10 percent of your income; that’s not including secured debts like your mortgage and car loan. Basically, the payments for this loan plus your credit cards should never exceed 10 percent of your tame-home income.
Debt Consolidation Loan FAQ
Can I get a debt consolidation loan with bad credit?
Consolidating with bad credit usually depends on just how bad your score is and how much debt you have. If you have a subprime credit score (FICO 500-600) you may be able to qualify for a small personal loan. However, there could be two issues:
- You can’t qualify for an amount large enough to pay off all your debts.
- You won’t get an interest rate that will be beneficial.
If you need to pay off $30,000 in credit card debt, then you probably need better credit to qualify for a loan that big. If the loan won’t pay off all your balances, then it’s not an effective debt solution.
The other consideration is the interest rate you can qualify for on the loan. If the lender will only offer you a high interest rate, then a consolidation loan won’t provide the benefit you need. The rate will be too high, meaning your payment still get eaten up by interest charges.
At the most, you want the interest rate on your debt consolidation to be 10 percent or less. Closer to 5 percent is the sweet spot where these loans can be the most effective.
Can you consolidate student loans and credit card debt?
Technically, you can consolidate student loans and credit card debt. But, it’s complicated…
Student loans are a specialized type of debt. Namely, it’s one of the few personal debts that can’t be discharged easily by bankruptcy. That’s true whether you have federal loans or private loans. It’s not impossible to discharge student debt, but it’s much less likely than discharging credit card debt.
Student loans also often have specialized interest rates. If you took out federal loans through FAFSA the rate the lender set the rate based on the 10-year Treasury note index. It had nothing to do with your credit score. Even private lenders often offer lower rates on student loans, giving special consideration to students.
Both of those factors make it problematic to consolidate student loans and credit card debt together. If you apply for a loan to consolidate student debt, the lender usually gives you student loan rates. However, they won’t give you that great rate and then let you use the funds to pay off other debts.
The other option would be to use a regular, personal debt consolidation loan and take some of the funds to pay off your student loans. But then the question becomes, is this really beneficial? Again, student loans tend to offer lower interest rates. So, if you use a personal loan to pay off a student loan, the rate may increase instead of decreasing. That makes it harder and less cost efficient to pay off your debt.
Also, be aware that this may mean that you lose eligibility for federal relief programs. You won’t be able to use federal repayment plans and, more importantly, you won’t qualify for loan forgiveness. Consider this option with extreme caution before you combine these two types of debt.
Can I use a home equity loan for debt consolidation?
Yes, but a home equity loan is not as good for credit card debt consolidation as a personal loan. The main reason is that you unnecessarily increase your financial risk by using a home equity loan for this purpose. Here’s why:
A home equity loan is a secured type of debt. You qualify for the loan, using your home as collateral. If you default on the loan, the lender can foreclose on your home. By contrast, credit card debt is unsecured. There is no collateral backing up the debt. If you default, the creditor must take you to civil court to recoup their losses. They can’t take your home or any other property to repay the debt (no matter what the collector tells you).
If you use a home equity loan to pay off credit card debt, you effectively convert unsecured debt to secured. This increases your risk because you create the potential for a foreclosure action. You may be fine making the payments now, but if you lose your job then default could happen.
This is why it’s generally not advisable to take out a home equity loan solely for the purpose of credit card debt consolidation. You’re much better off using an unsecured personal loan.
Does applying for a debt consolidation loan affect your credit?
Yes, but it affects your credit both negatively and positively.
- Applying for a loan can negatively affect your credit right after you apply. However, that’s only true if you’ve applied for a number of other loans or credit cards within the past 6 months. Too many new credit applications within a 6-month period can decrease your credit score slightly.
- A consolidation loan can positively affect your credit by fixing your credit utilization ratio. That’s the measure of how much credit you have in use versus your total available credit limit. It’s the second most important factor used to calculate your credit score.
Credit utilization only measures revolving debt – that’s any debt where the payment requirement changes based on your balance. The mostly refers to credit card accounts, which makes a consolidation loan extremely good for your credit score. Basically, once you consolidate with the loan, you drop your credit utilization ratio to zero. You are not using any of your available credit lines. That gives your score an immediate boost.
This provides a definitive benefit for consolidation loans versus the other type of do-it-yourself credit card debt consolidation. A balance transfer credit card also allows you to consolidate existing balances. However, you do so with a new credit card instead of a loan. In this case, you would only get the credit score boost once you eliminate the consolidated debt. With a personal loan, you get the benefit earlier.
In any case, be aware that any credit score benefit can be offset if you don’t stick to your solution. The most important factor used to calculate credit scores is credit history. That’s why missed payments have such a bad impact on your score. So, if you consolidate and then start to miss payment, it won’t be good for your credit.