Debt Consolidation Loans: What You Need to Know

Debt consolidation loans combine two or more debts into one, easy-to-manage monthly payment, though there are ways to consolidate debt without a loan.

Choose Your Debt Amount

What Is a Debt Consolidation Loan?

A debt consolidation loan is a financial strategy to pay off multiple high-interest debts with one, low-interest loan. It simplifies bill paying – and saves money – for consumers dealing with numerous unsecured debts like credit cards, medical bills or personal loans.

Debt consolidation loans work simply: You borrow what you need to pay off your debts, then make a single monthly payment to the lender.

The advantages are that debt consolidation loans usually carry a lower interest rate – which means less money paid — and there is only one check and payment due date each month. These loans usually have repayment terms of 2-to-5 years, depending on the amount borrowed.

A secured debt consolidation loan – just like a secured personal loan – is backed by collateral such as home, car or property and is the easiest route to consolidation.

Unsecured loans are backed only by a borrower’s promise to repay. If you want to go the unsecured loan route, add online lenders to the list of lending possibilities.

How to Get a Debt Consolidation Loan

You can find a loan for debt consolidation at the familiar places – banks, credit unions, online lenders – but do some research and comparison shop before choosing this option.

It is important to understand that debt consolidation loans do not eliminate debt. They restructure it, ideally in a more favorable way, but you still end up paying back what you owe. Before choosing a debt consolidation loan, do the homework that makes the process easier and the chances for success much higher.

Before consolidating debt:

  • Identify the bills you want to consolidate: Secured debts – like mortgages, auto or boat loans – usually don’t qualify for consolidation. Debt consolidation loans deal almost exclusively with credit card debt.
  • Examine your budget: How much of a monthly payment can you comfortably afford after taking care of the necessities?
  • Order your credit report: It’s free and it will note all your debts, including some you may have forgotten.
  • Check your credit score: It’s also available free via numerous online sources. It will be a factor in some of the loan options, so know where you stand and be realistic about what interest rates and terms to expect.

When to Use a Debt Consolidation Loan

The best time to consider a debt consolidation loan is when you want to pay off debt from multiple credit cards by reducing the interest rate.

Basic questions need to be answered before going ahead with this kind of loan. If your debt is less than 50% of income, consolidation may be a good option. If it’s more than 50% of your income, debt settlement or bankruptcy could be better options.

Among the questions to consider about consolidation:

  • Will I lower my payment?
  • Will I lower my interest rate? With interest rates overall at historic lows, finding a better rate should not be that challenging.
  • Will this help my credit? If your credit cards are maxed out, you’re using a ton of available credit. By taking out a debt consolidation loan and paying off the charges, you’ll lower your utilization rate, which can improve your credit score. Just be sure to make on-time payments once you consolidate.

If the answer to any one of the above three questions is yes, it’s worth looking into consolidating. You’ll have to qualify, but imagine the relief if this loan helps you get out of debt. However, you also must examine your budget and spending, or this same problem can persist.

Benefits of a Debt Consolidation Loan

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 the opportunity to improve your credit score over time by making timely payments. Paying back unsecured debt like credit cards will also drive down your utilization ratio, which accounts for 30% of your credit score.
  • You can save on interest every month if the rate of your debt consolidation loan is lower than the rate of your current debts. Usually, that is the case.
  • Your monthly payments may be lower if you extend your loan terms. This could offer some much needed breathing room, however, keep in mind it may cause you to pay more in interest over time.

Remember, if you have a low credit score or dings in your credit report, you may not be approved for a consolidation loan. Rates for consolidation loans in March of 2021 ranged from 6% to as high as 36%, so even if you are approved, your rate may be so high that it doesn’t make sense when compared against what you currently pay.

How Do I Qualify for a Debt Consolidation Loan?

To qualify for a debt consolidation loan, borrowers should have good or decent credit along with enough income to assure lenders they can repay the loan without delay. Debt consolidation loans are not only reserved for premium credit profiles, but locking in the lowest rates will require a high credit score.

Borrowers with spottier credit profiles may still be able to qualify for a debt consolidation loan, but the savings may be small or non-existent. If you have bad credit, you may be better off working on your score for a few months before applying. Or, consider exploring other debt consolidation options like a debt management plan.

Will a Debt Consolidation Loan Affect My Credit Score?

A debt consolidation loan can offer an opportunity to improve your credit score, but you must make timely payments. Use the loan as a part of your financial planning, not as a way to simply shift debt.

When you take out the loan, your lender will pay all your credit card debts. That reduces your credit utilization ratio, which improves your credit score. Paying on the new loan regularly and on time – this is important! — also helps.

However, this option also can hurt your credit score.

Opening a new credit account reduces the average age of all your accounts. This figure is part of determining your length of credit history. The longer you’ve shown you are reliable, the better your credit score.

Merely applying for a consolidation loan leads to a hard credit inquiry, which will lower your score by a few points. A hard inquiry is merely the check a financial institution does when you apply to borrow money.

If you don’t have a strong credit rating, contact a 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-to-5 years.

Be aware: 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

  1. Do your research: Different banks offer competitive loan rates and varying repayment terms. Keep your options open. Credit unions, most of which have easy membership qualifications, can compete with bank rates as well.
  2. 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.
  3. Make the loan a priority: Pay off the consolidation loan before taking on new financial responsibilities. 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.

Debt Consolidation Loan vs. Balance Transfer Card

Balance transfer credit cards are another way to consolidate debt that could reduce your interest to as low as 0%. These cards let you transfer the balance from all your credit cards to a single card and pay that off with no interest for an introductory period ranging from 6-to-24 months. However, there are a few things to consider before applying for one.

For starters, you will need a good credit score (680 or higher) to qualify for a card with a 0% intro rate. Lower credit scores may still qualify, but the interest rate likely will be higher. Also, pay close attention to balance transfer fees, which some credit card companies charge up front. Most cards charge 2%-to-3% of the amount owed. If you owe $10,000, that means another $200-to-$300 added to your bill.

Which brings us to the big question: Can you pay off your entire debt in the time frame allowed? If you don’t, the regular interest rate kicks in on the balance, and the range in late 2020 was somewhere between 16% and 25%.

Once again, do ALL the math, before deciding this is the right way to eliminate credit card debt.

Alternatives to Debt Consolidation

A debt consolidation loan is not for everyone. Alternatives are available.

Credit counseling is available for those unsure which way to turn. A counselor can go over your financial situation, and present options. Sometimes talking things through makes the situation clearer.

Debt management is a program run by nonprofit credit counseling agencies to help consumers eliminate credit card debt in a 3-to-5 year period. The counseling agencies go over your budget to determine a monthly payment you can afford. They then work with credit card companies to reduce the interest on card debt so you can safely make that payment every month.

Credit scores are not a factor in debt management programs. This is not a loan, but rather a monthly payment program that helps you get out of debt.

Home Equity Loans are a way homeowners can take advantage of their home’s equity to eliminate debt or pay for a range of costly expenses, like education, home improvement, or even vacation. The amount you can borrow is limited to 85% of your home’s equity, however, low interest rates and tax benefits can make these loans useful tools for savvy borrowers.

Debt Settlement can eliminate a large portion of the debt you owe. Some companies claim to cut your debt by as much as 50%. However, it’s rarely that simple. There are usually fees to pay to the debt settlement company that can cut into your savings. Not to mention, your credit score will take a beating.

Bankruptcy is something few people like to talk about, let alone consider. However, some borrowers reach a point where bankruptcy may be a wise decision. It can be a fresh start that puts you back on the right track, financially speaking. This isn’t a decision you should rush into or make alone. Talking to a certified financial counselor can help you determine if bankruptcy is, indeed, your best option.

About The Author

Bents Dulcio

Bents Dulcio writes with a humble, field-level view on personal finance. He learned how to cut financial corners while acquiring a B.S. degree in Political Science at Florida State University. Bents has experience with student loans, affordable housing, budgeting to include an auto loan and other personal finance matters that greet all Millennials when they graduate. He has a prodigious appetite for reading, which he helps feed with writing from Scottish philosopher Adam Smith, the “Father of Capitalism.” Bents writing also has been published by JPMorgan Chase, TheSimpleDollar and Interest.com.

Sources:

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