Struggling with debt? If so, you might be considering a debt consolidation loan. Before you take this step, you’ll want to understand how a debt consolidation loan works. There are certainly benefits to such loans—but there are also drawbacks. In this post, we’ll discuss how debt consolidation loans work in general, and we’ll list some of their pros and cons.
What is a debt consolidation loan?
A debt consolidation loan is a loan provided by a single lender that allows you to pay off all of your creditors. Rather than continuing to make multiple monthly payments to various creditors, you make a single monthly payment to the loan provider. This type of loan can potentially lower your interest rates and simplify your finances with a single payment. However, it can be difficult to qualify for and could have you paying more when you take origination fees of 3%–5% into account.
How does a debt consolidation loan work?
A lender loans you a lump sum of money, which you then use to pay off all your other creditors. By consolidating your debt into one place (the new loan) you can make a single monthly payment on that loan rather than trying to keep track of several payments to several different creditors.
What are the benefits of a debt consolidation loan?
The main benefit of a debt consolidation loan is that you can streamline your payments into one place, making it simpler to keep track of outstanding debt. Another benefit is that it could also help you save money in interest. If you have good credit, you could qualify for a loan that carries a lower interest rate than your previous debts, such as credit cards. This means a larger portion of your monthly payments would go toward paying down your principal debt amount. So you could potentially become debt-free quicker with a consolidation loan than if you continued to pay on multiple high-interest debts, like credit cards.
OK, so what are the risks?
Debt consolidation loans can be harder to qualify for. If you do qualify for a debt consolidation loan, you may not be approved for the full amount needed to cover your outstanding debts. Actual financing terms will be determined by your credit score. These types of loans are also subject to origination fees, which add to your overall debt. If you don’t think you’ll qualify for a favorable loan or cannot afford to pay back what you owe, this might not be the best option for you.
Is a debt consolidation loan right for me?
If you have great credit and can qualify for favorable loan terms (like the loan amount and interest rates) this could be a good option for you. A debt consolidation loan will allow you to reduce the number of creditors you have to deal with at one time by restructuring your debts into a single lender and payment. However, it’s also a good idea to consider all of your options before making a decision.
Alternatives to debt consolidation
Outside of debt consolidation, there are several alternatives to getting out of debt. The right strategy for escaping your debt will depend on your specific situation.
Debt settlement is another popular way to deal with debt. Debt settlement companies negotiate directly with creditors on your behalf to settle your debts for less than what is owed. These companies specialize in these types of negotiations and have greater leverage with creditors, and they could help reduce what you’re required to pay back by up to half or more. Reducing your overall debt could also help you become debt-free quicker.
Making extra monthly payments
Another strategy for getting out of debt quickly is to make extra monthly payments, as you’re able. This allows you to pay off your loans faster and saves you money in the long run since the faster you pay down your balance, the less interest fees you’ll be accumulating. You could save even more by prioritizing your highest interest debts and putting the extra payments toward resolving those first.. This approach is called the debt avalanche method.
Home equity line of credit (HELOC)
There are several options for borrowing against your home as you work to resolve your debt. These options include a line of credit, home equity loan, or cash-out refinance. While this may seem appealing, you should proceed with caution as these options leverage your house as collateral, meaning you could be at risk of losing your home if you default.
Bankruptcy is typically a last resort when dealing with debt. The process can cost a lot of money in fees and—depending on your income—you could lose certain assets or have trouble getting credit in the future. Check out our blog post on strategies you can use to avoid bankruptcy.
Borrowing from friends and family
While borrowing from friends and family can be tricky to navigate, it may be a good option if you’re facing severe financial difficulties. The main advantage is that when borrowing from a loved one, you’ll avoid the heavy interest rates and fees that come with most loans. However, borrowing from those close to you can lead to strained relationships (and awkward holiday meals!) if you aren’t able to repay them promptly. If you choose to go this route, we recommend setting clear repayment terms.
How can CreditAssociates help?
At CreditAssociates, our debt settlement services can help you drastically reduce your debt in as little as 24 to 36 months. After a single phone call, you’ll be set up with affordable monthly payments and a plan to pay off your debt for significantly less than you owe.
Common Questions about Debt Consolidation Loans
Should I get a loan to pay off my credit cards?
A loan to pay off your credit cards can be a good idea to help you start fresh. If you qualify for a lower interest rate on your new loan, it could also help you save money. However, as with credit card debt, it’s important to keep up with your loan payments to prevent a negative impact on your credit score.
Why might debt consolidation be a bad idea?
Debt consolidation might be a bad option for you if you don’t have good credit. Qualification and financing for these loans is based on your credit score. If you don’t have good credit or don’t qualify for a loan with a lower interest rate than your existing debt (like credit cards), debt settlement might be a better option for you as debt consolidation doesn’t reduce the amount you owe, but simply combines all your debts into a single payment. For more on settlement vs. consolidation, check out this blog post.
Will a debt consolidation loan hurt my credit?
Yes, debt consolidation loans can hurt your credit—but not for the reasons you might think. Your FICO score will be slightly reduced because taking out any kind of new loan will cause your credit rating to dip. Thus, to some degree, these loans can make it more difficult if you’re looking to borrow money in the near future. Your credit may also be hurt if you fail to make your monthly payments on time. If you don’t think you have the discipline to keep up with these payments or can’t afford to pay back what you owe, debt settlement might be a better option for you.
Is it better to get a personal loan or a debt consolidation loan?
There’s practically no difference between a personal loan and a debt consolidation loan. The only difference is that a personal loan can be used for any purpose, and a debt consolidation loan is primarily used to combine multiple debts into a single loan. Both loans could be used to help reorganize your debt into a single place and monthly payment. Learn more in our blog post on getting a loan to pay off credit card debt.