What Is Debt Consolidation?
Debt consolidation is a method used to combine all your debts into a single loan with a goal of simplification, lower interest rates and lower monthly payments.
The benefit of this approach is that you can pay off all your high-interest rate balances with the low-interest rate loan.
This eliminates the process of having to pay multiple statements every month and managing the balancing act of paying multiple small loans simultaneously.
What’s more, debt consolidation can also reduce your interest rate and help you pay off the debt even quicker.
This process alleviates the pressure of repaying high-interest loans and allows you to pay more principal debt off in a shorter amount of time.
High amounts of debt can put you in a difficult financial situation and could lead to bankruptcy if it is not managed appropriately. A debt consolidation loan may help you prevent this outcome and rebuild your credit
How Does Debt Consolidation Work?
A debt consolidation loan is similar to refinancing a loan. A new consolidation lender pays off each of your current outstanding loans.
The payments made to your current lenders cancel each loan agreement with them and merges all debts into one single new loan with the consolidation lender.
The difference between a refinancing loan and a debt consolidation loan is that a consolidation loan pays off multiple lenders, whereas generally, refinancing only pays off one loan.
There are various debt consolidation agencies, and their focus is to provide you with relief from your high-interest debt.
That said, circumstances differ between borrowers, so it’s essential to compare lenders to find a loan that matches your financial needs.
Simple Debt Consolidation Case Study
Here is an example of how a consolidation loan could work. Let’s say you have a total of $20,000 of debt owed over three credit cards and two personal loans.
Assume the average interest rate and APR total 25% annually among the five debts. Using a simple interest scenario at 25%, the $20,000 in debt owed would accumulate $5,000 in interest each year.
In reality, most personal loans and credit cards have compounding monthly interest and fees, which may be much higher than the example above.
While each scenario is different and will depend on your repayment schedule, high-interest debt is very difficult to pay off.
Using a debt consolidation loan with a 7% annual interest rate for the $20,000 debt in the above example would save $3,600 in interest per year. That’s a lot of extra money that could be used toward paying the principal debt off.
This scenario is simplified to illustrate the principle of consolidation lending.
Most personal loans and credit cards are based on compounding rather than simple interest. Therefore, the interest payments would be far higher per year.
Is Debt Consolidation Right For You?
A debt consolidation loan is one of the more popular debt-management options. They generally offer favorable terms and are more flexible with their payment options.
The three main benefits of debt consolidation are:
- Reduced interest payments
- Quicker payment of principal
- Simplification of debt load and management
You can compare online lenders here to find the lowest interest rates and best terms. It is essential to know your current interest rates and APRs are on each of your credit cards and personal loans.
There is no point consolidating if you are not reducing your interest rate.
Reduce Interest Payments
The primary purpose of debt consolidation is to reduce the high-interest payments in exchange for a lower interest debt consolidation loan.
💡 Tip: Taking out a debt consolidation loan does not reduce your debts.
While a debt consolidation loan will not lower the amount owed, your interest rate and payment terms will have been adjusted.
The hope is that you will be able to pay more principal off by reducing the amount of interest you need to pay annually.
A debt consolidation loan may be perfect for you if:
- You can afford to keep up payments until full loan repayment.
- You are using it as an opportunity to cut spending and get back on your feet.
- The loan will help you clear all the debts you have.
- Your loan payment is lower than all your minimum credit card payments combined.
Pay Off Principal
Debt consolidation loans are a great way to stop wasting hard earned money on high-interest payments. That extra cash saved can go towards your actual debt, allowing you to get out of debt faster.
Once you have a debt consolidation loan in place, your monthly payments should be paying off a higher ratio of the principal debt.
This provides the benefits of
saving you money on interest and paying down your loan balance faster.
Simplify Your Finances
If you have quite a few small personal loans and credit cards, debt consolidation can make your finances much more straightforward.
Often knowing where your money is going enables you to be more in control of your spending and can bring much-needed motivation to get out of debt.
How To Consolidate Debt?
If you are struggling to manage your debts it pays to have a plan. Start by talking to your lenders and writing down all your loans and credit balances.
Pulling your credit report from the reporting agencies can be an excellent way to get all these balances in one place. You can also use this report to verify there are no red flags or accounts that you don’t recognize.
With this information in hand, have a conversation with a credit counselor. They can guide you through a review of all your debts and help determine if a debt consolidation loan is right for you.
They may also recommend other avenues besides taking a loan.
If the credit counselor determines a debt consolidation loan is right for you, you can find multiple debt consolidation companies online.
Banks also offer some of the best debt consolidation loans.
Quick Pros and Cons
- Saves large amounts on interest payments
- Improves credit score over time
- Helps you pay off debt faster by paying a higher ratio of interest
- Simplifies your finances
- Reduces your credit score temporarily
- Bad credit scores may not allow you to qualify for a low enough interest rate to make debt consolidation worth it
- Spending habits will have to change, or you may find yourself in more debt than before
Alternatives to Debt Consolidation Loans
Debt consolidation loans are not your only option when you want to simplify your debt load.
A Secured Loan Vs. Unsecured Loan
A secured debt consolidation loan has a lower interest rate because there is collateral securing it. People often use the equity in their homes to get a second mortgage and pay off their debts.
While this will get you a stable interest rate and spread the payment over as many as 30 years, as you will have to put your home up as collateral, which is risky.
If you are a homeowner, you can apply for a home equity line of credit. HELOCs often provide the lowest interest in personal loans available. The credit is secured against the equity in your home, so you want to make sure you pay it off on time.
Balance Transfer Credit Card
A balance transfer credit card often offers an APR of 0% for a limited time, usually between 12 – 18 months. This means that your balance won’t incur interest charges during that time.
There is typically a transfer fee between 2% and 5%, which is charged. But other than that you won’t pay any interest.
This is a good option if you are determined to get out of debt and you have pre-budgeted a way to achieve this within a 12 to 18 month promotional period.
The downside of a balance transfer credit card is that if you don’t pay off your debt within that time, the interest rate charges will increase dramatically.
Our online loan calculator allows you to compare interest rates and APRs from a wide range of lenders without affecting your credit score. Try it now for free.
Avoiding Consolidation Traps
Ensure the decision to consolidate a loan is reasonable. The rates need to be much lower than the rates of the debt you are consolidating. Also, keep an eye out for any early repayment penalties.
Consider the loan term. Even if the interest rates are low, a longer term could mean more fees and interest. Always read the terms carefully and verify that your lender is licensed.
Like most lending facilities, when used correctly, debt consolidation can be a great tool. It is vital to make sure that you have found a much lower interest rate than your current credit cards and loans.
There is limited value in consolidating debt if you’re going to move it to an account with a similar interest rate to your current accounts.
The other thing to consider seriously is how committed you are to getting out of debt. Consolidation works very well with a budget and a set goal.
It is recommended to cancel the credit cards that the consolidation loan has paid off.
It is also essential to change your habits, so you don’t find yourself in more debt than when you started.
Consolidation Loan FAQs
Will debt consolidation affect my credit?
In short, yes. Debt consolidation may reduce your credit score in the short term. Applying for any new loan will lower your credit score temporarily because of a hard inquiry on your credit score as well as a new loan against it.
What is a hard inquiry?
When applying for any loan, the lender will perform a hard inquiry on your credit score. This will drop your credit rating slightly and temporarily.
Why does the new loan go against my credit score?
Once your debt consolidation loan has been approved, it will then be registered to your credit score. This will be displayed on your credit report. New accounts often lower credit scores briefly.
Could debt consolidation improve your credit score?
In short, yes. Although your credit score will drop momentarily, consolidating your debt may increase your score over time due to your utilization ratio dropping as you pay off the debt
What is a utilization ratio?
Your credit utilization ratio] or utilization rate is the amount of credit you are currently using divided by the credit you have available. Let’s revisit the scenario above. Consider a debt of $20,000 (the credit you are presently using) over four credit cards and small personal loans.
If those cards are not maxed out, and the actual credit limit or credit available to you is $40,000, then your utilization ratio would be 50%.
When you consolidate your debt into one account and close the credit cards and personal loans, it will drop your credit limit to the exact debt amount, which is $20,000.
Your utilization ratio makes up 30% of your credit score, so you want to keep it as low as possible.
A high utilization ratio would indicate that you are spending a lot of your monthly income on paying off debt. This suggests to a lender that you don’t have much disposable income for future purchases.
Keeping your utilization ratio low will increase your credit score quickly. It can take less than 45 days to see a score improvement when the ratio is lowered.