Debt Consolidation Loans
What is debt consolidation?
Debt consolidation is a process where multiple high-interest debts — like credit cards — are rolled into a single payment. Debt consolidation simplifies your repayment structure and can make it easier to keep track of your remaining debt and may help you pay it off faster.
While there are multiple ways to consolidate your debt, borrowing a debt consolidation loan from a lender, bank or credit union is one of the most common methods.
How does debt consolidation work?
There are several ways to consolidate debt, but the general process entails taking out a new debt — in this case, a personal loan — to pay off multiple debts and streamline the repayment process. Borrowing a home equity loan or taking out a balance transfer credit card are also methods of debt consolidation.
However, a debt consolidation loan is one of the most common and easiest ways to consolidate debt. With fixed interest rates and monthly payments, it's possible to save money over the life of your loan by securing a lower rate than what you had on your previous debts.
Plus, a debt consolidation loan is an unsecured debt, meaning you don't need to secure the loan with collateral and run the risk of losing your assets, like your home, if you're unable to make the monthly payments. If debt consolidation isn't an option, working with a credit counseling agency to establish a debt management plan may be a better way of dealing with your debt.
How to apply for a debt consolidation loan
Applying for a debt consolidation loan is like applying for any other lending product, but you'll want to pay special attention to each lender's interest rates. Debt consolidation only makes sense if you can secure a lower rate than that of your previous debts.
Start by prequalifying with lenders, banks and credit unions to check your predicted rates and eligibility odds without impacting your credit. Look through the eligibility requirements of each lender and sift through the predicted rates, terms and fees to find the best loan for your situation.
Once you've narrowed down your search, look into each loan's benefits and potential drawbacks. Look for perks like autopay discounts or member benefits that will add to the value of your loan, and be on the lookout for value detractors, like origination fees. From there, you can find the best loan for your credit situation and apply online, or depending on the lender, you may be able to complete the process in person at a brick-and-mortar location.
Where to get a debt consolidation loan
Debt consolidation loans are offered through online lenders, banks and credit unions. While most applications can take place completely online, there are some in-person lenders that may require you to go to a physical location for the application process.
Pros and cons of debt consolidation loans
Before signing on the dotted line, it's important to be aware of the potential benefits and drawbacks that come with a debt consolidation loan. Here's what you need to know.
Pros
- Simplified payments: Debt consolidation turns multiple payments into one fixed monthly payment. Only having to make one payment a month — as opposed to four or five — can help encourage healthy repayment habits.
- Lower rates: Borrowers with above-average credit can qualify for lower interest rates and save money in interest over the life of the loan.
- Improve credit health: Consolidating your debts into one payment can help you grow your credit faster through simplifying the repayment process.
Cons
- Potential fees: Many loans come with fees, like prepayment and origination fees that can eat into the overall value of your loan.
- Doesn't pay down debt: While consolidation can help make your debt more manageable, it doesn't actually pay it down, and you'll still have to make the monthly payments.
- Doesn't solve overspending: If run up revolving accounts, like credit cards, or continue to live outside your means a debt consolidation loan may only offer temporary relief.
How do I choose the best debt consolidation loan lender?
It's important to find a debt consolidation loan that fits your budget and helps you reach your goal of eliminating debt. Many lenders offer prequalification, which gives you a prediction of the rate, loan amount and loan term that you could qualify for without making a hard credit inquiry.
You can then use the offers to compare options and decide which is best for you based on several factors.
- Annual percentage rates: Your APR is determined by your credit score and other financial factors. This is the amount charged on top of your principal amount every month.
- Loan cost: When you shop, compare the total cost of each loan, including origination fees and other charges. A large number of fees can outweigh the benefits of a low APR.
- Lender features: Potentially helpful features to search for are benefits like direct creditor payments, credit monitoring, hardship programs and 24/7 customer service availability.
Why consolidate your debt?
Debt consolidation has many potential benefits.
- Potentially lower interest rates: If you have several credit cards with double-digit interest rates and you qualify for a debt consolidation loan at a lower rate, you can potentially save thousands in interest and fees.
- Pay off debt sooner: Combining all the debt into one bucket can make it easier to pay the debt off sooner because you don’t have to balance separate payments.
- Simplified finances: Credit card rates are variable and your monthly payments differ depending on your balance, so it can be hard to know when your debts will be paid off. Debt consolidation puts all of your payments in one place so you can keep track of it easier.
- Set repayment schedule: A debt consolidation loan combines multiple debts into one monthly payment with a fixed rate and a set repayment term, so your monthly payments stay the same. You don’t have to worry about multiple due dates or varying payment amounts.
- Credit score improvement: Credit scoring models, like FICO and VantageScore, place a lot of weight on your credit utilization ratio. When a new consolidation loan lowers your credit utilization ratio, your credit score might climb as a result.
Generally, a debt consolidation loan is a good idea if you can pay off the new debt, you have a high credit score to get good rates and you like the stability of a fixed monthly payment.
Although a debt consolidation loan can be helpful for many people, it won't solve your financial problems on its own. To reap the full benefits and avoid further issues, you’ll need to avoid making late payments and keep balances low on your recently paid off credit card accounts.
Alternatives to a debt consolidation loan
Home equity
One popular way people pay off debt is to use the equity in their homes. Home equity loans and home equity lines of credit (HELOCs) let borrowers use their homes as collateral in exchange for financing. Just be sure to factor in the risks if you’re considering this option. The lender can seize your home if you can't make the payments.
Who this is best for: Borrowers who have built up equity in their homes.
Who this is not good for: Those unsure of their ability to maintain the monthly payments.
Home equity loan versus debt consolidation loan: Home equity loans and HELOCs may offer lower rates than debt consolidation loans, though they come with more risks, since your home is used as collateral.
Debt relief services
Debt relief services, commonly referred to as debt settlement companies, offer another way to deal with your debt if you can’t qualify for a consolidation loan. These companies reach out to creditors and debt collectors on your behalf and try to settle the debt for a lesser amount. If you decide to pursue debt relief services (perhaps as an alternative to bankruptcy), be aware that the fees these companies charge can be steep. Take your time to fully research fees, reviews and other details before applying. It’s also wise to compare multiple debt relief companies before you commit.
Who this is best for: Borrowers who are experiencing financial hardship and cannot pay their debt.
Who this is not good for: Those with a thin credit history or less-than-stellar credit score.
Debt relief services versus debt consolidation loan: Unlike debt consolidation loans, debt relief services aim to eliminate some of your debt without you having to pay it. With that said, pursuing debt relief is a risky move, and it can damage your credit score.
Credit counseling
Another option that can help you get debt under control is credit counseling. Credit counseling companies are often (though not always) nonprofit organizations. In addition to debt counseling, these companies may offer a service known as a debt management plan, or DMP.
With a DMP, you make a single payment to a credit counseling company, which then divides that payment among your creditors. The company negotiates lower interest rates and fees on your behalf to lower your monthly debt obligation and help you pay the debts off faster.
DMPs are rarely free, though, even if they’re done by a nonprofit credit counseling service. You may have to pay a setup fee of $30 to $50, plus a monthly fee (often $20 to $75) to the credit counseling company for managing your DMP over a three- to five-year term.
Who this is best for: Borrowers who need help structuring their debt payments.
Who this is not good for: Those with little wiggle room in the budget.
Credit counseling versus debt consolidation loan: With a debt consolidation loan, you're in control of your payoff plan, and you can often apply with few fees. With credit counseling, a third party manages your payments while charging setup fees.
Balance transfer credit card
With a balance transfer card, you shift your credit card debt to a new credit card with a 0 percent introductory rate. The goal with a balance transfer card is to pay off the balance before the introductory rate expires so that you save money on interest. When you calculate potential savings, make sure you factor in balance transfer fees.
Keep in mind that paying off existing credit card debt with a balance transfer to another credit card isn't likely to lower your credit utilization ratio like a debt consolidation loan would.
A debt consolidation loan also is going to offer higher borrowing limits, enabling you to pay off more debt, as well as fixed monthly payments, which make it easier to budget and stay disciplined with paying off debt.
Who this is best for: Borrowers who can pay off existing debt quickly.
Who this is not good for: People with a young credit history or a less-than-average score.
Balance transfer credit card versus debt consolidation loan: Balance transfer cards are often the best choice for borrowers who have the means to pay off their debt within 18 months, which is a standard 0 percent APR period. If you need longer to pay off your debt, or if you have a lot of debt, a debt consolidation loan is a better choice.
How the 2022 Fed rate hike affects debt consolidation loans
In an effort to combat rising inflation, the Federal Open Market Committee (FOMC) raised interest rates by three-quarters of a percentage point in June, July, September and November. These rate hikes have caused interest rates on personal loans to rise.
Most personal loans have fixed rates, meaning that borrowers who already have a personal debt loan for debt consolidation do not need to worry. However, those looking to take out a new loan may face higher rates.
If you are in the market for a debt consolidation loan and want to ensure you get the best rate possible, there are some steps you can take.
- Prequalify if possible.
- Check your credit score before applying.
- Apply with a co borrower.
- Shop around and compare rates.