Do you have a mountain of debt looming over you — various credit card balances, medical bills, and installment loans that have piled up? If you’re ready to take the reins and turn the situation around, a debt consolidation loan may be able to help. But it won’t be right for everyone. Debt consolidation can possibly lower your interest, but it may not lower your overall costs.
Debt consolidation can be a helpful solution when you’re juggling multiple debts and want to streamline repayment. Here are a few of the top reasons why.
If you have high-interest debt, a debt consolidation loan with a lower interest rate can help to lower your borrowing costs. For example, Americans carrying credit card debt pay an average annual percentage rate (APR) of 20.68%, while the average APR on a 24-month personal loan is just 11.48%, according to the latest data from the Federal Reserve.
| For example: Let’s say you had $5,000 of credit card debt with an average APR of 22% and a monthly payment of $150. Your overall interest would be $2,798, and you’d end up paying $7,798 over the course of four years. However, if you were to consolidate that debt into a personal loan with a 12% APR and a loan term of five years, your monthly payment would decrease to $111, and your overall interest would be $1,673. You’d end up paying $6,673, with a savings of $1,125 in interest over the life of the loan. |
Managing multiple debt payments each month can be stressful and time-consuming. It also increases the likelihood that one of your payments will eventually slip through the cracks. Debt consolidation combines multiple debts into a single loan, which streamlines your payment process — you’ll just need to remember one amount and one date per month.
Debt consolidation can also help you pay off debts faster because you’ll combine them all into a single installment loan with a monthly payment and a set term. It can be harder to see the light at the end of the tunnel when you have multiple revolving credit lines that only require minimum monthly payments.
If you’re using a debt consolidation loan to pay off credit card balances, your credit utilization rate will drop, which will likely result in a significant credit score boost.
Credit utilization is based on revolving account types like credit cards and lines of credit, so your new installment plan won’t count toward it. Additionally, consistently making on-time payments on your new loan will help to move your credit score in the right direction.
Here are a few of the downsides of debt consolidation loans.
Unfortunately, there’s no guarantee that a debt consolidation loan will end up lowering your borrowing costs. Those with fair-to-poor credit scores (a FICO score below 670) may find that they can’t qualify for a rate that would justify undergoing debt consolidation. You’ll need to run the numbers on your current debt costs and the costs of a debt consolidation loan to see if the savings are there or not. Additionally, consolidating your debt with a loan that has a longer repayment term will likely cost you more in interest in the long run.
Paying off your credit cards and other debts with a consolidation loan can help to improve your credit scores, but it can also leave you with newfound credit available. If you don’t change the habits that got you into debt, you risk acquiring more, which can leave you with an even bigger problem.
While the end goal is to pay off your debt and improve your credit reports and scores, you may see initial drops. Here’s why:
When you apply for a debt consolidation loan, lenders typically look for a reliable income source and a good payment track record. They want to ensure they’ll get their money back and earn a profit.
To get approved for a loan large enough to consolidate multiple debts at a competitive rate, you’ll need to have good credit and steady, verifiable income (in a high enough amount). If you don’t, you may have trouble getting approved.
Various types of financial institutions offer debt consolidation loans, including banks, credit unions, and alternative lenders. In many cases, you can apply online and get an answer the same day. Here’s how it works:
A debt consolidation loan can be a great solution if it reduces your interest costs, streamlines your payments, and helps to improve your overall financial situation. For example, if you have good credit and want to pay off multiple high-interest credit cards, it could make sense.
On the other hand, debt consolidation typically won’t be the best route if your credit is in rough shape or you don’t have enough income. Lenders may deny your applications or approve them with low loan amounts and high-interest rates. It’s also a high-risk choice if you think you’ll be tempted to run up your credit card balances again.
If debt consolidation doesn’t sound like the best move, you can consider other options, including:
Debt consolidation can cause a temporary drop in your credit score due to the hard inquiry that’s required to get the loan and the addition of a new loan with a large outstanding balance. However, your score should recover and improve once the various debts are paid off, your credit utilization drops, and you begin making on-time payments on the new loan.
No. Most lenders restrict you from using your personal loan funds to consolidate your student loans. However, you can consolidate your student loans separately by refinancing a private loan or consolidating a federal loan into a Direct Consolidation Loan from the federal government.
You can consolidate many types of debt as long as they aren’t associated with illegal activities. Lenders don’t typically review your debts or pay them off for you. You request the loan in an amount that will cover your debts and then use the funds to pay them off yourself. However, there are lenders that will pay off your creditors directly.
Yes. If you pay off your credit card balances using a debt consolidation loan, you’ll be able to use the cards to make purchases up to your available credit limits. But keep in mind that continuing to use your credit cards could dig you into a deeper debt hole and negate the main benefits of debt consolidation.
The amount of time it takes to pay off your debt through debt consolidation will depend on multiple factors, including the total amount you owe, the monthly payment amount you can afford, and the rate you can get on a debt consolidation loan.
Lenders vary in how they respond to missed payments but will often contact you about the late payment and request you get up to date as soon as possible. Late fees may apply.
If the payment remains unpaid for 30 days or more, lenders will usually report it to one or more of the consumer credit bureaus, which will negatively impact your credit score for seven years. Continued late payments can result in lenders sending the account to collections or suing you to recover the balance.
If you’re unable to make a payment, it’s best to contact the lender as soon as possible to try to make payment arrangements and avoid any negative repercussions.