A debt consolidation loan is a type of financing for people that have multiple debts. It allows them to consolidate (or combine) all of their debts into one new loan.
While debt consolidation loans can be used to consolidate various types of personal debt, the most common use is for credit card debt. The loan is intended for people with multiple credit cards who are struggling to make more than the minimum monthly payments to their creditors.
How Does a Debt Consolidation Loan Work?
Debt consolidation requires a great deal of discipline and a willingness to live modestly. The most important thing to remember about how a debt consolidation loan works is that it doesn’t change the amount you owe. It merely pays off your existing debts with a new loan, which must also be repaid.
Essentially, you are replacing many loans with one, hopefully at an improved interest rate and monthly payment amount.
Before doing anything, assess your ability to repay the loan. How much money can you afford to put toward it each month? Also, determine if you are paying off a secured or unsecured debt. Consolidation loans are geared toward unsecured debt (credit cards, medical bills, utility or rent payments) rather than secured debts (home or auto) that have collateral behind them.
Benefits of Debt Consolidation Loans
Consolidation loans can be a worthwhile solution for consumers with heavy debt that is dispersed amongst multiple credit cards. Essentially, a consolidation loan allows you to pay credit card debts in full and the new loan is established in their place.
Taking out a consolidation loan is beneficial in the following ways:
- May reduce the number of collection calls you receive from multiple creditors
- Allows you to make one monthly payment to one source
- Provides you the opportunity to improve your credit score over time by making timely payments
Secured vs. Unsecured Debt Consolidation Loans
The two basic types of consolidation loans are secured and unsecured. Secured loans are tied to an asset (house, car, piece of property) that is used as collateral in the event that you default on your loan. Unsecured loans are not tied to an asset and are based largely on your credit history because you are considered high-risk for a lender.
Secured Loan: positives and negatives
+ Easier to obtain from a lender
+ Higher borrowing amount allotted
+ Lower interest rate
+ Possible tax deductible interest rate
– Longer repayment terms (higher cost in interest over time)
– Risk of losing assets
Unsecured Loan: positives and negatives
+ No asset risk
+ Shorter repayment term (lower cost in interest over time)
– Harder to obtain from a lender (high risk borrower)
– Lower borrowing amount allotted
– Higher interest rate
– No tax benefit
The easiest type of consolidation loan might be a 0% interest credit card balance transfer. If your credit is fairly strong, a card company could allow you to cluster the debt from several cards and put them all on one card with no transfer fee and no interest payment for a limited time, usually 12-18 months.
Another option is a consolidation loan from a credit union or peer-to-peer online lender. Qualifying requirements usually are less stringent than banks. Your application is evaluated quickly and the interest rates typically are more favorable than what you currently are paying.
How Will a Debt Consolidation Loan Affect My Credit?
A debt consolidation loan can provide an opportunity to improve your credit if you use it as a financial plan, as opposed to just shifting debt around. When you take out your consolidated loan, your credit card debt will be paid in full and you will focus on paying down your single new loan.
If you need to take out a consolidation loan, it is safe to assume that your credit has already taken a hit with delinquent payments. As your score won’t immediately improve, timely payments on the new loan will start to positively impact your credit rating over time.
If you don’t have a strong credit rating, talk with a credit counselor at a nonprofit credit counseling agency to review other options. They may recommend a debt management program that will help you set up a budget and pay off the debt within 3-5 years.
Be aware that not every financial problem can be solved through a debt consolidation program. There are some situations where debt settlement or even bankruptcy are the best solution to the problem.
Helpful Tips to Remember When Entering into a Debt Consolidation Loan Agreement
- Do your research. Different banks offer competitive loan rates and varying repayment terms. Keep your options open, as often times credit unions can contend with the bank’s competitive rates as well.
- Stick to a budget. Before you settle on your consolidation loan’s monthly installments, measure your income against your expenses to determine a realistic monthly payment.
- Make the loan a top priority. Don’t inquire about your eligibility for new credit card promotions or run up any additional debt on your existing cards, as both of these will have a negative effect on your credit score.