If you open three credit card statements, you’ll see three different interest rates which can make debt seem worse than it is. A debt consolidation loan is a loan that will combine multiple balances into just one loan, one payment, and hopefully a lower interest rate. This can make repayment easier, but this is only possible if the new deal is less expensive and you do not incur additional debt following the purchase of the new deal.
What Exactly is A Debt Consolidation Loan?
A debt consolidation loan typically involves a personal loan that’s employed to settle several debts. You borrow one amount, pay off the credit cards, medical lenders or finance companies, and then make payments for a fixed term to the new lender.
Imagine you owe $3,000 on one credit card, $4,500 on another, and $2,500 on a store card. Your total debt is $10,000. If you are eligible for a $10,000 consolidation loan, you can make three payments and consolidate them as just one payment each month.
The money never goes away. “Consolidation” just means that the content is organized differently. The advantage could be that the expense will not rise, due dates are reduced, and the payoff will be transparent.
Understanding debt consolidation
Typically, debt consolidation loans are fixed rate loans with constant monthly payments.
Assume that you owe $15,000 on your credit cards and the average interest rate is 24%. A three-year consolidation loan at an 11 percent interest rate would cost approximately $491 a month and interest of around $2,700. That might be a lot less expensive than carrying the balances at 24%.
The result can vary according to the fee. If there is a 5% origination fee on the loan, the $15,000 loan will cost an additional $750. That fee may be subtracted from the amount received, and you may end up with only $14,250, while still owing part of the old debt.
Are there ways to make money using debt consolidation?
The debt consolidation loan only saves the money if its total cost is lower than the total cost of the current debts. Look at the annual percentage rate, fees, repayment period and total amount repaid, and not only the monthly payment advertised.
Switching to a personal loan, which charges 12%, from a 27% card can result in significant savings. It could be convenient to replace it with a 6% fee on a 24% loan but the price won’t be cut all that much.
The loan period is also a factor. The payment on a $12,000 loan for 3 years at 10 per cent is approximately $387 and the interest expense is approximately $1,940. If the loan is extended to a five-year period of time, the monthly payment is approximately $255, and the total interest paid is approximately $3,300.
If you don’t want to do that, there are other ways to consolidate debt
It may be possible to use a balance transfer credit card instead of a personal loan. These cards can provide a temporary 0% interest rate and usually have a transfer fee.
If you transfer that $8,000 to the new credit card, with a 3% balance transfer fee, you’ll pay an additional $240. If you were to pay the full $8,240, over 15 months with no interest to be paid, you would be paying approximately $550 per month. If there is any amount remaining after the end of the offer, then the interest on the remaining balance may be accrued at the standard rate.
A home equity line of credit or loan should be considered by homeowners. It may be a lower rate as the home is securing the borrowing, but failure to pay the loan may jeopardize the property.
A nonprofit debt management plan can furthermore include repayments without forming a new loan. A credit counselor can arrange to lower the interest rates and make a single monthly payment to your creditors. It’s not debt settlement, which aims to negotiate with creditors for a settlement that’s less than what’s owed.
When Consolidation Works, and When It Does Not
It seems to be most effective when you are earning a steady income, have a low monthly debt burden and have an excellent credit score that is good for obtaining better terms. Think of a person who is paying $620 per month for four cards. With a new loan, the necessary payment is lowered to $470. The additional $150 paid would be applied to principal with the amount paid being the same at $620, and if there was no prepayment penalty, the amount of time required to pay off the loan could be reduced.
However, if expenditure is greater than income the plan will be less likely to succeed. If you have a monthly budget deficit of $400, then taking out a new loan is not going to plug the hole. It could just open up the opportunity to take out more debt.
The consolidation may also break down if cards that have been paid off are used again. If a person borrows $20,000 and then adds another $6,000 after four cards have been cleared from the loan, how much will he owe? The problem has turned into a $20,000 installment loan and $6,000 in new charges to their credit card bills.
Be wary of debt consolidation firms that offer debt settlement. Unpaid bills, collection notices, charges, adverse credit reports and lawsuits are all possible for settlement programs. Before you sign up for anything, inquire about what services it provides.
How Consolidation Affects Your Credit Score
When you apply for a loan, a small bump in your credit score can be caused by the lender’s credit score check.
If you pay your bills on time and decrease your credit card balances, consolidation can help over the long haul. For cards that have a combined limit of $20,000 with balances of $14,000, your utilization rate is 70%. If you were to pay those balances off with an installment loan, then that would have a dramatic effect on card utilization, even though the new loan would be on your credit report.
How to Select the Best Option
Record each balance, interest rate, minimum payment due, and anticipated payoff period. Then compare those numbers with the annual percentage rate, fees, monthly payment, term and total amount repaid of the new offer.
Consolidation could save money if you are in debt for $9,000 at an average interest rate of 22% and are offered a deal at 10% with a small fee. When the offer is 20% for seven years, the lesser payment can be a hidden higher offer.
The payment should be within your normal budget once you account for housing, food, transportation, insurance and saving. Give yourself the breathing room that is afforded by having an additional $300 to spare in case of an unforeseen $300 repair bill.
The Bottom Line
Debt consolidation loans can help to ease your finances and cut off the interest rates, but they cannot get rid of your debt. It is effective if the new loan is less costly, the monthly payment is affordable, and you avoid rolling balances over on the accounts that you paid off.
Compare total costs rather than focusing only on the advertised rate or a smaller payment. Check the fees, repayment term, and type of service being offered. The right plan should give you a clearer path out of debt, not simply move the debt somewhere else.
Frequently Asked Questions
Is a debt consolidation loan bad for your credit score?
A new application may cause a small temporary score drop. Consistent on-time payments and lower credit card balances may help your credit profile over time.
What credit score is needed for a debt consolidation loan?
There is no universal minimum because lenders use different approval rules. A stronger credit score usually improves your chances of receiving a lower interest rate and fewer fees.
Is a balance transfer better than a debt consolidation loan?
A balance transfer can be cheaper if you qualify for a long 0% APR and repay the balance before it ends. A fixed-rate loan may be better when you need more time and want a predictable monthly payment.
Disclaimer:
This article is for general educational purposes only and does not provide financial, legal, tax, or credit advice. Loan products, rates, fees, and regulations vary by lender and location.
