Personal Loans

How Does Debt Consolidation Work Pros and Cons

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 10 minute read

Shauna was one of the many Americans who lost her job when the COVID-19 outbreak hit. When her small emergency fund was depleted, she began relying on credit cards to make ends meet. She charged $8,500 to four separate credit cards in just three months.

Shauna is back at work, but she is struggling to make ends meet because of her massive credit card debt. She is currently spending $255 monthly merely to meet the minimum payment requirements. It will take her about 17 years to pay off the sum at the current pace, and she has no idea what she will do if interest rates increase.

A debt consolidation loan can help people like Shauna get out from under their mounting debts. Not everyone will benefit from this, but those who have trouble keeping up with many interest-heavy bills may find it helpful.

What Is a Loan for Debt Consolidation?

Simply put, debt consolidation is the process of combining multiple monetary obligations into one. If you have many loans or credit cards, consolidating them into one loan can reduce your monthly payment obligations. To repay the new debt, you continue making your regular monthly installments.

A debt consolidation loan’s primary benefit is the potential for improved repayment conditions relative to your current debts. The interest rate or the regular payment might be reduced, for instance. For this reason, employing one can help you save money and reduce your debt more quickly.

Debt Categories That a Loan Can Consolidate

Unsecured debts, such as credit card balances and personal loans, can be consolidated into one manageable monthly payment with the help of a debt consolidation loan. Still, these plans are most helpful for people who have a lot of debt with steep interest rates or pricey regular payments.

Certain instances are:

  • Credit card debt
  • Unsecured personal loans
  • Unpaid medical bills
  • Payday loans

Consolidating your student loan debt with other debt may be an option for you. However, because of the complexity of the regulations around these loans, it may be more convenient to consolidate student loans independently or seek out another method of refinancing.

Who Can Get a Debt Consolidation Loan?

A debt consolidation loan is not always simple to obtain. Lenders take extra precautions to ensure these borrowers can meet the payments on a new loan because they know those seeking these loans have problems paying their existing debts. 

Some of the things they consider are:

  • How Good Is Your Credit? Good credit is a priority for most lending institutions. A score between 650 and 700 is required. Although the interest rates on debt consolidation loans for people with low credit are typically higher, there are still a few lenders who will work with those who have poor credit.
  • You’re Credit Record. Loan companies will also check your credit report. They will check your credit history for red flags including bankruptcies, foreclosures, repossessed vehicles, and debts sent to collections.
  • Spending Money. For this kind of loan, many financial institutions stipulate a minimum yearly income. In most cases, they will require a letter from your current or most recent employer detailing your job duties, employment history, and current income.
  • Debt to Income Ratio. How much of your take-home pay goes toward your monthly debt payments is known as your debt-to-income ratio (DTI). To qualify for a debt consolidation loan, your DTI must be below 50%, and certain lenders may require even lower amounts.

What’s the Process of Debt Consolidation?

A debt consolidation loan with a set interest rate is the most typical method used for this purpose. You take out a loan big enough to cover all your other obligations, and then you start making payments on that loan. 

As a rule, a consolidation loan will either reduce your monthly payment or shorten the length of time it takes to pay off your debt. Traditional banks, credit unions, online lenders like SoFi, and peer-to-peer lending platforms are just some of the hundreds of lenders who offer this type of loan. 

It’s common for debt consolidation loans to have a duration of one to five years and to be used to pay off anywhere from $1,000 to $50,000 in debt, though the specifics are flexible. 

Unsecured loans make up the vast majority of those used for debt consolidation. Some companies that provide debt consolidation loans also provide secured loans, which can be collateralized by anything of value like a property or a car.

It may be less difficult to qualify for a secured loan, and you may be able to borrow more money at a cheaper interest rate. However, the interest rates on even the riskiest unsecured loans are typically much more reasonable than those on credit cards.

Additional Debt Consolidation Methods

There are other options available besides a fixed-rate loan for debt consolidation. There are alternate choices, but they all have serious drawbacks. 

For example:

  • Transactions Involving the Transfer of an Existing Balance. To eliminate your credit card debt entirely, consider applying for a balance transfer credit card that doesn’t charge you any interest. In order to qualify for one of these cards, you’ll need to have a high credit score, and you’ll be restricted to making small balance transfers. Also common are 3%-5% balance transfer fees. On average, the introductory 0% APR term lasts for no more than 21 months before reverting to the standard variable APR.
  • Equity Loans for Homes. The equity you have in your property is the market value minus the remaining debt. To borrow up to 80% of your equity, and in some cases, even more, you can use a home equity loan or home equity line of credit (HELOC). In comparison to unsecured loans, home equity loans and lines of credit typically feature lower interest rates and longer repayment durations. However, in order to qualify for one, you’ll often need to have at least 20% of the purchase price already paid off.
  • Loans Taken Out of a 401(k) Plan. You may borrow up to the lesser of $50,000 or 50% of your vested account balance from your 401(k). You will then have five years to repay the loan. Low-interest rates and access even for those with weak credit make these loans appealing. The major drawback is that they can threaten your retirement funds if you don’t repay them on time.

How to Acquire a Loan for Debt Consolidation

To get a debt consolidation loan, first determine how much you need and how much you can afford to pay each month. Next, hunt for loan offers that meet these requirements. You should compare the terms and rates offered by several financial institutions, beginning with your present bank or credit card firm.

Prequalification for online debt consolidation loans is available from some lenders right away. This method simplifies the task of comparing various loan offers down to their finer details. And since acquiring loan quotations typically doesn’t necessitate a hard credit check, it won’t have any negative effect on your score.

Keep interest rates and fees in mind while you shop for the best loan terms. It’s important to keep in mind that the origination costs attached to some debt consolidation loans can amount to anywhere from 1% to 8% of the total amount borrowed. Fees for processing checks or dealing with late payments are another possibility.

If you acquire a loan, put it toward paying off your other debts immediately. If you cannot pay off all of your debts with the loan proceeds, prioritize those with the highest interest rates. Don’t rush to close your old accounts, as doing so can have a negative impact on your credit rating.

Advantages and Disadvantages of Debt Consolidation

Consolidating Shauna’s debts seems like the best option for her financial situation. She is currently only able to make the minimum payments on her credit cards, and it will take her years to pay them off. With a debt consolidation loan, she may reduce her payment amount each month, allowing her to pay off her debts more quickly.

Nonetheless, a loan to consolidate debts isn’t a panacea. They have major drawbacks that Shauna would have to consider carefully to see if they are acceptable.

Advantages of a Loan for Debt Consolidation

The advantages of a debt consolidation loan are as follows:

  1. Requires Less Paperwork. It’s easy to get disorganized when dealing with various loan and credit card installments. Not making a payment when it’s due can result in late penalties and negative effects on your credit. A debt consolidation loan allows you to reduce your monthly financial obligations to just one installment. Since the payment is always the same amount, setting up an automated withdrawal will ensure that you never miss a payment.
  2. Spend Less on Debt Payments. Consolidating debt often results in cheaper interest rates than individual credit cards or high-interest loans. This results in a smaller payment each month for the same total debt.
  3. Decreased Enthusiasm. Unlike with credit cards, the interest on a debt consolidation loan does not accumulate. To rephrase: you are not charged interest on interest. As a result of these two factors, you will end up paying less interest overall on your debt.
  4. The Payoff Occurs More Quickly. Making only the minimum payment on credit cards might extend the repayment process by years, even decades. The term of a fixed-rate loan may be counted on to be a specific number of years. Because of the decrease in your interest rate, you can pay off your loan faster without increasing your payments. However, the loan period plays a role in this, as will be seen in the following section.
  5. Liberation From Creditor Harassment By taking out a new loan to consolidate debt, you can quickly eliminate your previous bills. You are free from the burden of dealing with debt collectors.
  6. The Probability of a Credit Score Improvement. If you open a new line of credit and keep the existing ones open, your total credit will go up. This will lead to an increase in your credit score. It will get even better as you continue making payments toward the principal. However, debt relief options like bankruptcy and debt settlement can have a negative impact on your credit score.

Disadvantages of a Loan for Debt Consolidation

There are some disadvantages to getting a debt consolidation loan, such as:

  1. Expenses that Must Be Paid Up Front. A loan’s balance transfer or origination fee may be charged by the lender. These costs may end up outweighing any interest savings. You should also be aware that there may be a prepayment penalty attached to certain of your older loans.
  2. Few Available. The amount of debt that can be consolidated with a loan of this type is restricted. The standard cap is $50,000, though certain lenders may have a lower limit in place.
  3. Negative Debt Reduction. Consolidating debts isn’t the same thing as getting out of debt. It won’t help you pay back less money, unlike debt settlement or forgiveness.
  4. Possible Rise in Overall Compensation. The interest rate on a debt consolidation loan is typically lower than the interest rate on your previous obligations, meaning you end up paying less overall. There is a risk that your monthly outlay would rise if the new loan has a longer repayment term. You may end up spending more money if there are more installments to make despite the fact that each one is smaller than the others.
  5. There’s a Chance Your Credit Will Be Harmed. Your credit score will drop slightly if you apply for a new loan. In addition, a credit score looks more favorably on older debts with a longer payment history than on newer obligations with a shorter history of payments. Increasing your overall available credit may not be worth the risk, at least in the short term, due to this damage.
  6. A Possible Loss of Assets. It is challenging to obtain an unsecured loan for debt consolidation if your credit is less than stellar. However, your assets will be in danger if you take a secured loan, which is why their approval rates are lower.
  7. Is Not a Solution to Budgeting Issues. Getting a loan can help you catch up on your past-due payments, but it won’t fix the issues that led to your debt. Like Shauna, you may find that you need a loan to resolve a temporary financial issue. If you have a history of overspending, though, paying off your debts may just leave you with more available credit to use for further purchases.

Should You Consider Debt Consolidation?

Those with low-interest rates and high amounts of unsecured debt may not benefit from consolidating their debt. 

Several factors must be considered, among them:

  • How Good Is Your Credit? A low-interest debt consolidation loan or a credit card that doesn’t charge fees for transferring a balance to it are both options for people with good credit. If you have average or below-average credit, getting a loan could mean paying higher interest rates or putting your valuables up as collateral.
  • Spending Money. If you want to get approved for a debt consolidation loan and then keep up with the payments, you need a reliable source of income. To pay off your loan in five years or less, your salary should be sufficient.
  • A Measure of Your DTI. All of your monthly bills, including your rent or mortgage, and your other loans should not exceed half of your take-home pay for your debt repayment plan to be effective. Getting a loan may not be an option if your DTI is above that level. Credit counseling and debt settlement might help you get out from under your debt burden.
  • The Way You Normally Spend Money. Consolidating debt is an effective strategy for coping with debts brought on by events that have passed, such as a temporary loss of income or one-time medical expenses. However, if you have persistent spending issues, you should focus on those first. Consolidating your debt won’t help in the long run if you don’t create a budget that can support your lifestyle.

Bottom Line

To be successful with a debt consolidation loan, payments must be made on time. Setting up automatic payments is the simplest method. Borrowers who select this option may qualify for discounts from some debt consolidation lenders.

You should also refrain from incurring any more debt while paying off the old. If you want to avoid running up additional credit card debt, start using debit cards instead of credit cards for your routine expenditures. Only charge necessary purchases until the loan is paid in full.

It is most important to create a budget and then follow it. Make sure your monthly expenses don’t exceed your income by finding ways to save money or increase your earnings. Getting out of the debt cycle is possible if you learn to live within your means and stop engaging in harmful financial behaviors.

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