How Debt Consolidation Loans Work
Debt consolidation is the consolidation of several debts into a single loan with a single monthly payment and a single interest rate (hopefully lower). This can help you stay organized and possibly save money, especially when you have a lot of debt and you don’t seem to be making any progress in paying off what you owe.
However, not all debt consolidation loans are the same. Understand how they work and weigh the pros and cons of these loan products before deciding if they are right for you financially.
What is a debt consolidation loan?
A debt consolidation loan is a way to refinance your debt. You will apply for a loan for the amount you owe on your existing debts and, once approved, you will use the funds to pay off your outstanding debts. Then you will repay the new loan over time.
When choosing a debt consolidation loan, you will need to assess features such as:
- Type of loan: The most common types of loans include personal loans, credit cards with a 0% introductory APR, 401(k) loans, and home equity loans.
- Loan conditions : The loan amount, interest rate, and loan term depend on the type of loan you get and your financial health.
- Secure versus insecure: With a secured loan, you must post collateral. For example, a home equity loan is secured by your home. If you are late in payment, the lender can take this security to settle your outstanding balance. If you don’t want to risk your assets, consider sticking with your unsecured options, such as personal loans and 0% APR credit cards.
How does a debt consolidation loan work?
Most debt consolidation loans are fixed rate installment loans, which means the interest rate never changes and you make a predictable payment each 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 credit cards, leaving you with one monthly payment to manage instead of three.
Let’s say you are paying off credit card debt. Here’s how a debt consolidation loan can help you save on interest charges:
- Card 1 has a balance of $5,000 with an APR of 20%.
- Card 2 has a balance of $2,000 with an APR of 25%.
- Card 3 has a balance of $1,000 with an APR of 16%.
If you pay off those credit card balances over 12 months, your interest charges would 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%. If you pay off the loan in one year, you reduce the interest charges to just $440. To calculate savings on your own debt, try using a credit card repayment calculator and a personal loan calculator.
Benefits of a debt consolidation loan
If you’re looking to save money, streamline your monthly payments, and circle the payment date on your calendar, debt consolidation may be right for you. Here is a breakdown of the main benefits:
- Pay off your debts faster. Making the minimum payment on your credit cards can stretch your repayment schedule for years. A debt consolidation loan can put you on the path to faster repayment.
- Save on interest charges. Generally, if you qualify for a lower rate than you are currently paying, you will save money on interest charges. Since the beginning of May 2022, the average credit card interest rate was 16.41%, compared to the average personal loan rate of 10.28% in January 2022.
- Simplify your monthly payments. It’s easier to manage one monthly payment than multiple payments with different due dates. This reduces your chances of missing payments, which is good for your credit.
- Repay on a fixed schedule. Many debt consolidation loans are fixed payment loans, which means you’ll know exactly when you’re debt free. It can help motivate you while you pay off your debts.
Risks of a debt consolidation loan
You will need to weigh your immediate needs against your long-term goals before moving forward. Some people choose to consolidate their debt to save money and organize their monthly payments, but there are downsides to consider.
- This will not solve all your financial problems. Once you’ve used the debt consolidation loan to pay off your debt, you might be tempted to start using your credit cards again. This increases your overall debt, which can impact your credit and make it harder to pay off your balances.
- There may be an initial charge. Some debt consolidation loans come with fees, including origination fees, balance transfer fees, prepayment penalties, annual fees, and more. Before you take out the loan, ask the lender if any of these apply.
- You can pay more interest. This can happen in two ways. Depending on your credit score, debt-to-income ratio, and loan amount, you may pay a higher interest rate than you would have paid on the original debt. Or, if you use the debt consolidation loan to reduce your monthly payment by extending your repayment term, you could end up paying more interest in the long run.
Debt Consolidation Loan Interest Rates
When you pay off a debt consolidation loan, you’re not only paying back the amount you borrowed, you’re also paying an extra amount each month in the form of interest. Interest rates on debt consolidation loans generally range from 5.99% to 35.99%. A higher interest rate will cost you more over the life of the loan than a lower interest rate. Each lender has different criteria for setting rates, so shopping around can help you find the best deal.
Typically, lenders check these factors when deciding if you qualify and setting your interest rate:
- Your credit score: Borrowers typically need a credit score in the mid-600s to qualify for a debt consolidation loan, and a higher score can help you get a lower interest rate.
- Your DTI ratio: Your debt-to-income ratio (DTI) tells lenders how much of your monthly income is spent paying down debt. Lenders tend to look for a lower DTI ratio.
- Revenue: The lender will verify your employment and verify that you earn enough to make payments.
If you don’t quite meet the credit requirements, you may be able to find a lender willing to give you a loan, even if you can get a higher interest rate. If this is your situation, consider adding a co-signer to the loan. This person promises to take over the payments if you fall behind – so they need to understand what this entails before saying yes.
How to Apply for a Debt Consolidation Loan
There’s a bit of legwork involved, but it will pay off if a debt consolidation loan saves you money. Start by applying for your credit, comparing quotes from multiple lenders, and checking your chances of getting approved for a loan.
- Understand your finances. A good credit rating gives you a better chance of qualifying for a debt consolidation loan and getting a good interest rate. Check your credit rating before applying to see if it needs work.
- Compare lenders’ terms. Searching for the best deal can help you save money on debt consolidation. Get quotes from multiple lenders and compare interest rate, fees, loan term and monthly payment.
- Get prequalified. Some lenders offer prequalification, which gives you an idea of the type of offers you might receive. Many can only complete a simple credit application, which means prequalifying won’t affect your credit score.
- Gather what you need to apply. When applying for a debt consolidation loan, you may need your social security number and contact information, an estimate of your monthly debts, and a pay stub and employer information to prove your revenue.
Once you are approved, the lender can disburse your loan proceeds to your creditors or send the funds to you. Make sure the original debt is paid off, then get to work on your new loan. Set up automatic payments or use reminders to make payments on time each month. Over time, you will be debt free.
At the end of the line
You may be able to pay off your debt balances much sooner and save a lot of money with a debt consolidation loan. You’ll also enjoy the convenience of making just one payment per month instead of worrying about paying multiple lenders on time. However, you might incur additional costs that you didn’t have before, and you might get a higher interest rate.
Ultimately, you want to assess your situation and analyze the numbers to decide if a debt consolidation loan is right for you financially. It’s equally important to focus on developing good money management habits over time.