Key learning points
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Debt consolidation combines multiple debt streams into one loan with a fixed monthly payment.
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Only consider a debt consolidation loan if you are offered a lower interest rate than your previous loans.
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Debt consolidation loans can only help you control your debt burden if you can make the monthly payments feasible, both now and in the future.
Debt consolidation is a popular way to manage and organize high-interest debt. This strategy involves consolidating multiple debts into one account, often with a lower interest rate, to streamline repayment.
Understanding how debt consolidation works is crucial to selecting the best approach for your situation. You can choose from different types of loans. Fortunately, it’s not too difficult to find someone who has taken out a debt consolidation loan and can share their experiences. Bank Lending Editor Rhys Subitch tells us how they’ve benefited from this and what they’ve learned along the way.
How does debt consolidation work?
What is Debt Consolidation? Debt consolidation combines multiple loans into one fixed monthly payment.
Debt consolidation only makes sense if the interest rate on your new loan or line of credit is lower than the interest rates on the debts you are consolidating. To maximize your overall savings, focus first on consolidating the debts with the highest interest rates. Keep the term of your loan as short as possible.
If your monthly payments are a bit too high for your budget, you may be able to extend the term of the loan. While this may be cheaper at the moment, you will end up paying more interest in the long run.
Most debt consolidation loans have a fixed interest rate, meaning the interest rate never changes and you make the same 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 cards. You only have to manage one monthly payment instead of three.
Let’s say you’re paying off your credit card debt. Here’s how a debt consolidation loan can help you save on interest costs.
- Card 1 has a balance of $5,000 with an APR of 20 percent.
- Card 2 has a balance of $2,000 with an APR of 25 percent.
- Card 3 has a balance of $1,000 with an APR of 16 percent.
If you pay off these credit card balances in twelve months, your interest costs will 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 percent. Paying off the loan in one year reduces interest costs to just $440.
To calculate your potential savings through consolidation, use a credit card payoff calculator and a personal loan calculator.
What is the difference between debt consolidation and a personal loan?
Debt consolidation is a form of debt refinancing in which the borrower takes out a loan, credit card, or line of credit and uses it to pay off other debts. This promotes debt repayment because the borrower only has to worry about making a single payment each month.
Plus, there is the potential to save money later if they manage to secure a lower interest rate.
There are several ways to consolidate debt, including personal loans.
Personal loans are a type of installment loan, with a fixed interest rate and repayment term. Some lenders market personal loans specifically for debt consolidation. Debt consolidation loans generally have terms of one to seven years, and many loans allow you to consolidate up to $50,000.
But debt consolidation isn’t the only way borrowers can use personal loans. Personal loans can be used for almost any purpose, from financing major purchases to home improvement projects.
What to look for in a debt consolidation loan
If you’ve ever applied for a loan before, chances are you know what to look for. However, because consolidation loans involve multiple debt streams, that monthly payment can add up quickly.
When trying to find the best option for your situation, compare at least a few lenders and pay close attention to the features. The loan details are on the lender’s website or on the terms and conditions page.
The details to look out for include (but are not limited to) the loan type, term, and whether it is secured or unsecured.
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There are several types of debt consolidation options, including:
- Personal loan. These are often unsecured, with a fixed interest rate and a repayment term of one to seven years.
- Credit card balance transfer. These cards often offer an introductory 0 percent APR period that lasts between 12 and 18 months, followed by a variable interest rate. Good to excellent credit is often required to qualify. Only credit card debt can be transferred to these accounts. There are typically balance transfer fees of between 3 and 5 percent of the outstanding balance.
- Mortgage interest deduction. Mortgage loans allow homeowners to tap into their own equity and borrow against it. The house serves as collateral, so interest rates can be more competitive.
- Home equity line of credit (HELOC). Similar to home equity loans, HELOCs use your home as collateral and allow you to tap into your home equity. However, the main difference is that borrowers can withdraw money as needed for a specific period of time. The interest is often variable.
The type of loan you choose determines the:
- Admission requirements. Refund Terms.
- Interest rates.
- Minimum and maximum loan amounts.
- Types of Debts You Can Consolidate.
For example, a personal loan allows you to consolidate multiple types of debt, such as medical bills and credit card debt. With a balance transfer card, on the other hand, you are limited to consolidating credit card debt.
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A longer loan term can make your monthly payments more affordable. But it means you pay more interest over the life of the loan.
It may be that a shorter repayment period is better. Despite higher monthly costs, you pay much less interest and you are debt-free faster. Before choosing a term, evaluate your budget and avoid stretching your finances too thin. -
Secured debt is easier to qualify for and usually comes with lower rates because the balance is backed by collateral. This means that the lender will require you to put up an asset in order to be approved. Depending on the loan requirements, this could be anything from a security deposit to a vehicle or even your home.
If you don’t make the payments or repay the loan, the lender can seize your collateral to make up for the delinquent payments. Unsecured loans are less risky for the borrower because they do not require collateral. However, it is generally more difficult to get approval for it.
How to Manage a Debt Consolidation Loan
The most important thing after taking out a debt consolidation loan is to avoid taking on more debt. Additional debt can defeat the purpose of getting the loan in the first place.
It is also important to stay on top of payments. This will help you make progress and protect your credit score from taking a dip. One way to do this is by scheduling automatic payments.
“Using automatic payments is a real fear-buster for me. I don’t have to worry about missing a payment, and it’s one less task every month,” says Subitch.
They add that they now only have one payment instead of three, and that they can pay a little extra each month if they have enough money.
Additionally, some lenders offer a rate discount if you choose this payment method, increasing your savings.
However, life is unpredictable. You may be going through a rough patch, making it difficult to keep up with your monthly bills.
If that happens, it’s critical to be proactive and contact your lender. Although it may seem inconvenient, lenders often have options that can temporarily reduce or pause payments in the event of difficulty. This, in turn, will keep your account current while you get back on your feet.
How do you know if a debt consolidation loan is right for you?
Debt consolidation is not the best option for everyone. In Subitch’s case, it made sense because it aligned with their long-term financial goals.
“My debt consolidation payment is a pretty big chunk of change,” says Subitch. “In total, my minimum payments would have actually been lower than the debt consolidation loan, but it would also have taken significantly longer to pay it off in full.”
A debt consolidation loan is worth considering if:
- You qualify for a lower interest rate. If you have good or excellent credit and plan to consolidate your credit card debts, you will likely get a lower interest rate on a debt consolidation loan than you currently have on all of your credit cards.
- You want a predictable monthly payment. The interest rate on most debt consolidation loans is fixed, meaning you’ll get a predictable monthly payment that you can work into your budget. But a debt consolidation loan only makes sense if you can afford this amount.
- You prefer to pay one creditor every month. Instead of having to pay multiple creditors on the due dates, you only pay one creditor per month. This could make it easier to avoid late fees and adverse credit reporting.
However, if your credit score is fair or worse, you are unlikely to qualify for a debt consolidation loan with a lower interest rate than you currently have.
It’s also best to avoid taking out a debt consolidation loan if your estimated monthly payment is higher than what you can comfortably afford. In this case, you may want to explore other options, such as contacting creditors to negotiate a payment plan.
it comes down to
Before you decide to consolidate, research your loan options and details and assess your finances.
“Sit down and calculate your budget,” Subitch advises. “Make sure that even if it is more than your minimum monthly payments, it is manageable.”
If you can qualify for a debt consolidation loan with a lower interest rate and a reasonable monthly payment, this can be a great way to streamline debt payoff and save money on interest. But if payments are still out of control after exploring multiple offers, it may be best to look at other alternatives for relief.