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 help you manage your debts, but only if you can afford to make the monthly payments now and in the future.
Debt consolidation is a popular way to manage and organize high-interest debt. This strategy bundles multiple debts into one account, often with a lower interest rate, to streamline repayment.
Understanding how debt consolidation works is crucial to finding the best approach. You can choose from different types of loans. Fortunately, it’s not 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.
What is debt consolidation and how does it work?
What is Debt Consolidation? Debt consolidation combines multiple loans into one monthly payment.
Debt consolidation only makes sense if the interest costs of your new loan or line of credit are lower than the interest costs of the debts you are consolidating. To maximize your overall savings, focus on consolidating the debts with the highest interest rates first.
Keep the term of your loan as short as possible. You may be offered an extended loan term. While this may be more affordable at the moment, you will end up paying more interest in the long run.
Many 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.
Imagine you have three credit cards with different interest rates and minimum payments, then you can use a debt consolidation loan to pay off those cards. You only have to manage one monthly payment instead of three. 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 over a twelve-month period, your interest costs will total $927. Let’s say you take out a 12-month personal loan for the amount you owe – $8,000 – with an APR of 12 percent. Paying off the loan in one year reduces interest costs to just $711.
To calculate your potential savings through consolidation, use a credit card payoff calculator and a personal loan calculator.
Debt Consolidation vs. 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.
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 on your debt consolidation loan.
“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 for using this payment method, increasing your savings.
However, life is unpredictable. You may be experiencing an issue that is making it difficult to keep track of your monthly bill.
If that happens, it’s critical to be proactive and contact your lender. Although it may seem inconvenient, lenders often have the option to temporarily reduce or pause payments in the event of difficulty. This in turn ensures that your account stays current while you get back on your feet.
How do you know if a debt consolidation loan is right for you?
A debt consolidation loan 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 less 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 commit to consolidating, make sure you understand how these loans work, compare debt consolidation loan options, 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 the payments are still out of control after exploring multiple offers, it may be best to look for alternatives for relief.
