What Is Debt Consolidation?
Debt consolidation is a method used to merge all your debts into one loan account with lower interest. The purpose of doing so is that you can pay off all your high-interest rate balances with the low-interest rate loan.
This puts a stop to you having to pay multiple statements every month and performing a balancing act as you try to pay down many 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.
Debt can create a messy situation and could even lead you to bankruptcy. A debt consolidation loan may help you prevent this 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 various outstanding loans canceling your loan agreement with previous lenders and merges them into one new loan.
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 find a loan that matches your financial needs.
Simple Interest Scenario
Let’s say you have $20,000 worth of debt owed over three credit cards and two personal loans.
The average interest rate and APR total 25% annually over the five debts. At 25%, if your debt owed was accumulating simple interest, you would be paying $5,000 annually.
Most personal loans and credit cards will have compounding monthly interest and fees, which is much higher.
This will depend on your repayment schedule, of course, but either way, that’s a lot of extra after-tax dollars you need to earn to pay off that loan.
If you took that $20,000 worth of debt and merged them into a debt consolidation loan with a 7% annual interest, you would save $3,600 in interest per year. That’s a lot of spare money you could be putting towards paying the principal debt off.
This scenario is simplified for you to understand the principle of consolidation lending.
Most personal loans and credit cards work off compounding interest, not simple interestest. 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, paying off more principal, and simplifying your debt load.
You can compare online lenders here to find the lowest interest rates. It is essential to know what your interest rates and APRs are on your current 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 personal loan interest payments in exchange for a lower interest debt consolidation loan.
💡 Tip: Taking out a debt consolidation loan does not reduce your debts.
You will still owe the amount, but 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 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
It is a great way to stop wasting hard earnt money on high-interest payments. That extra money can then 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 means that not only are you saving money on interest, but you are paying down your loan 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, you need to talk to your lenders and write 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 all this information in hand, have a conversation with a credit counselor. They can help guide you through all your debts and 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, this is risky, as you will have to put your home up as collateral.
Unsecured loans may be viewed as a favorable option since there is no risk of losing the property. You can compare dozens of lenders offering debt consolidation loans here at Financer.com.
If you are a homeowner, you can apply for a home equity line of credit. HELOCs are often 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 has an APR of 0 for a limited time, usually between 12 – 18 months. What this means is that your balance won’t incur interest 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 period.
The downside of a balance transfer credit card is that if you don’t pay off your debt within that time, then you are back to paying a high-interest credit card.
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 total amount of 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 means more fees and accrued interest in the long run. 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 a similar interest account. Actually scrap that. It is a waste of time.
The other thing to consider seriously is how badly you want to get 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 account has paid off.
It’s 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, and to some degree, that is true, but only short term. Applying for any new loan will lower your credit score for a 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 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 can increase your score over time due your utilization Ratio.
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. Going back to our scenario above, take your 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.
When you consolidate your debt into one account, 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 than 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.