What is Debt Consolidation?

The term debt consolidation implies a borrower that applies for a new loan and utilizes the loan money to repay other individual debts. The debt normally ranges from auto loans and credit card balances to other personal loans.

What is a debt consolidation loan, and how does it work?

Debt consolidation loans can be considered personal loans used to repay debts with high-interest rates like credit cards. The loan allows borrowers to pay off several debts through a single loan, which helps simplify the monthly payments. Depending on the amount of debt and loan terms, this can save both time and money.

Debt consolidation loans typically work by having the debts cleared directly by the lender or through the borrower when they take out cash to pay off the outstanding balances. Once the previous debts are cleared, the borrower will pay only a single monthly payment of the new loan.

Debt consolidation typically lowers the amount of monthly payments by increasing the loan duration. This system also streamlines payments, thus, making it much easier to handle finances.

Suppose you have a total outstanding debt of $20,000 across four different credit cards with an annual percentage rate of 16% – 25% and say your credit score saw an improvement since the application of the existing card; this may qualify for the balance transfer card set with an introductory annual percentage rate of 0% that enables you to clear the credit card debt interest-free for a certain set period.

Types of debt consolidation loans

These are the different debt consolidation loans available for potential borrowers:

Debt Consolidation Loan

These can help streamline payments, lower interest rates, and at times improve loan terms. It’s a type of personal loan that’s typically available via credit unions or traditional banks. However, potential borrowers can also find numerous online lenders that practice it.

Credit Card Balance Transfer

These are card-based, whereby the borrower avails a new card (usually with low introductory rates) and transfers every existing balance to the new one. As with any type of debt consolidation, this also provides a single payment and a lower credit card repayment.

Student Loan Consolidation

These mainly combine multiple federal-backed student loans into a single government-backed loan. It helps lower and simplify monthly payments and also offers the advantage of protection for the borrower, such as PSLF (Public Service Loan Forgiveness).

Home Equity Loan

Debt consolidation with a home equity loan forms a type of loan secured by the borrower’s home equity. A lump sum is typically issued for the borrower to consolidate or repay existing debts. Since the loan includes collateral, it likely qualifies for a much lower interest rate.

About Debt Consolidation and Debt Settlement

Debt consolidation and debt settlement are both often used interchangeably. However, there are specific essential components that differentiate the two. Debt settlement usually hires and pays a 3rd party company to negotiate a lump-sum payment, which each creditor will accept instead of paying the entire outstanding balance. These companies usually charge a fee of 15% – 20% of the entire debt amount and often tend to be a scam.

On the contrary, debt consolidation requires borrowers to clear their total debt amount through money funded by a new loan. Except for charges like origination or other administrative fees, borrowers are not entitled to pay/hire anyone to finish the consolidation process. Instead, the process calls for borrowers to hold inventory over the debts and create a plan to pay the new loan.

Where to Get a Debt Consolidation Loan?

You can start your search on debt consolidation loans with different financial lenders like traditional banks and credit unions, which you utilize for banking and lending needs. You may also want to look at online lenders as they may provide cheaper options at times. The more options, the better the chances of discovering the best loan that suits you.

After comparing the options available to you, you can look for factors beyond the interest rates. For instance, lenders often offer both variable and fixed rates, so you’ll want to make similar loan comparisons.

In addition, consider components like the loan amount, repayment terms, and origination fees to find a suitable fit. Many times, the best debt consolidation loans come with flexible repayment terms, low-interest rates, and low or no fees.

Debt consolidation loans and bad credit

Loan approval often depends on your credit score. Every lender will go through the score if you’re applying for one. Hence, you may not qualify for the loan if your credit score is too low. Again, many lenders approve loans even with bad credit. However, the interest rate will likely be higher, which increases the overall costs and potentially makes monthly payments less affordable.

Do consolidation loans hurt your credit score?

Consolidation loans can affect credit scores in several ways – both good and bad. Here’s a look at how it does so:

• Credit utilization ratio: This ratio is the available percentage of the credit card you’re using. Maintaining a ratio below 30% is important to keep a fair credit score since a high ratio can result in poor credit scores. So, when your credit card debts are cleared through a consolidation loan, which takes place in installment credit that leaves the ratio untouched, it can drop the ratio to 0%, which helps your credit score.
• The average account age: Each time a new credit account is opened, it can decrease the average account age, influencing the duration of credit history. It may not be as important as utilization ratio or payment history, but it still impacts your score.
• Payment history: Making monthly payments on time helps improve the credit score gradually. However, you skip your payment for over a month, and your score will be affected severely.
• Hard credit inquiry: With each loan you apply for, lenders will find it challenging to review the credit reports, and this, in turn, can reduce your credit score.

What happens when you get a debt consolidation loan?

In simple terms, it will combine your entire debt into one mode of payment, and if done correctly, your interest rates will also be lower once the loan amount is processed. If you applied for the credit card mode of the loan, then once you get your consolidation loan, you’ll no longer pay the interest of multiple cards. Similarly, if you applied for the fixed-rate debt loan, you will only pay a single loan instead of multiple debts and interests rates.

Is debt consolidation a good idea?

Personal loans like debt consolidation are a great way of eradicating multiple debts. Here are some reasons why debt consolidation is a great idea if:

• You’re willing to clear off the entire debt amount through a consolidated loan.
• You have a good cash flow to cover the monthly repayments.
• You’re committed to paying off the loan over an extended period and maybe even make early payments.
• You have an improved credit score now and may qualify for much better (lower) interest rates.
• You’re planning to avoid collecting huge amounts of debts or financial issues.

You may also want to consider debt consolidation loans if you have:

High-interest Debts

If you’re able to qualify for lower interest rates than what you currently pay, consolidating your debts can allow you to spend much lesser on interest charges.

Good Credit Score 

If you maintain a great credit score, you can apply for debt consolidation on favorable terms with a much lower interest rate.

Repayment Plan

Credit cards are based on revolving credit that allows you to clear the funds without much of a repayment plan. Therefore, if you keep paying the minimum each month, you can potentially stay in debt for quite a long time. However, consolidated personal loans offer borrowers a specific repayment term, making it easier to clear funds and manage their finances.

That said, debt consolidation might not be a good fit if:

• You’re not prepared to take additional measures to clear off debts.
• You’re not planning on avoiding unnecessary future debts.
• You may not be able to cover the monthly payments of the new loan.
• Your outstanding debt can be cleared in a year or under. Hence, you wouldn’t save much through consolidation.

What are the risks of debt consolidation?

No loan comes without risk, even debt consolidation, and so here are some risks involved in debt consolidation:

• Higher Overall Cost: When your loans are consolidated, monthly payments tend to become smaller than before. However, that extends the loan duration, possibly resulting in a higher overall loan cost.
• Extra-High Charges: Debt consolidation likely comes with various charges and fees like documentation, origination, late payment, pre-payment charges, etc., that may be paid during transfer.
• Loss of Collateral: Depending on the lender, your loan may have to be secured with some sort of collateral like property. Hence, if you’re unable to make repayments on the loan amount, you will lose the valuable asset placed as collateral.

Debt consolidation can offer an effective way to clear debts, but it’s important to keep in mind the risks involved before signing up for it.

Advantages of debt consolidation loans

These are some of the advantages of applying/seeking debt consolidation loans:

• It offers a streamlined payment mode, thus, making it much easier to handle finances and debt by combining multiple loans into one.
• It can decrease the borrower’s overall interest rate through consolidation in the form of a secured loan, low-interest personal loan, or interest-free credit card balance.
• It may decrease the overall monthly debt payment by increasing the loan term duration.
• It can help borrowers clear off debts, especially those with huge amounts, much sooner.

Disadvantages of debt consolidation loans

These are some of the advantages that come with debt consolidation loans:

• Lenders often charge loan origination, balance transfer, or closing fees.
• It may require the borrower to put their home/property as collateral.
• It does not always guarantee lower interest rates, especially against borrowers with a poor/low credit score.
• The longer repayment period can affect the overall cost, possibly increasing it.

Summary

Deciding to consolidate debts does not come easy or simple. You’ll have to properly understand which route suits your best, along with the processes and factors associated with the loan.

You should definitely consider your need for consolidating the debts, your capacity to repay on time, and your commitment to not managing future debts before getting on board with the loan.