Rolling over credit card balances month after month can cost you thousands of dollars in interest every year. The combination of low required minimum payments and double-digit interest that compounds daily can also mean extending the payoff over three decades when paying only the minimum amount due, even if you stop using all your credit cards.
When faced with this hopeless dilemma, many consumers turn to debt consolidation as a strategy to reduce debt and lower their monthly payments. Before you consider debt consolidation as a strategy to tackle your high-interest credit card debt, here is what you need to know.
- Debt consolidation loans can simplify debt repayment and save money if you qualify for a loan with favorable terms.
- You must qualify for a debt consolidation loan, requiring a review of your credit and proof of income.
- Debt consolidation loans do not typically extend beyond seven years, which could shorten the time to become debt-free, but come with higher monthly payments.
- It is possible to convert credit card debt into a debt consolidation loan secured by your home. However, that route is rarely a good option because it puts your house at risk if you are unable to make payments.
- Before agreeing to consolidate debt with a consolidation loan, compare the cost savings by evaluating the interest rate, loan fees, monthly payment, and any prepayment penalties.
What is Debt Consolidation?
Debt consolidation is a debt relief strategy used to convert your high-interest debt, such as credit card bills, into a new, unsecured, personal loan with a lower interest rate. There are several debt consolidation options available to consumers burdened with high-interest credit card debt. Consolidating several debts into one loan creates simplicity with a single monthly payment instead of paying multiple debts with different due dates, interest rates, and varying monthly payments. You could secure a fixed interest rate, a set time frame to pay off the debt, and the same amount due every month helping you to better manage monthly cash flow.
Another strategy is to use credit card balance transfer offers to move balances from one or more cards with high-interest rates to a new credit card with a lower interest rate or deferred interest for an introductory period. While this strategy still consolidates balances into one payment, you are still paying daily compounded interest, albeit at a slightly lower rate.
The process of consolidating debt does not actually pay off any bills. Instead, it transfers multiple balances from one or more creditors to another single creditor with the goal of either saving money in interest payments or simplifying the repayment process.
How Does a Debt Consolidation Loan Work?
The first step to obtaining a debt consolidation loan is to complete a personal financial review. Without a clear understanding of how much you owe and the cost of your existing debt payments, you cannot accurately decide if the new loan is the best choice. When reviewing your current liabilities, record the following information:
- Type of debt (loan or line of credit)
- Current balance
- Interest rate
- Monthly payment
- The total amount you will pay under the current payment plan
- The time it will take to pay off the debt under the current arrangement
You can use a credit card repayment calculator for more accurate figures. Keep a tally of each account along with the accumulated totals to compare with the new loan.
Once you understand your needs, you can compare your options to determine if a debt consolidation loan will provide a more efficient way to eliminate your debts.
Traditional banks, credit unions, and online lenders offer debt consolidation loans. In many cases, the process is completed entirely online, and you can receive approval and funding within a few days. The lender will evaluate your credit history and require proof of income before finalizing the loan.
Can You Qualify for a Debt Consolidation Loan?
Most banks only lend money to borrowers with good to excellent credit and a good history of on-time payments. This is especially true if the loan does not include collateral, such as a home or vehicle the creditor can take if you fall behind on your payments. However, in the case of debt consolidation loans, many online lenders specialize in lending to borrowers with less than perfect credit. The key difference in these cases is the interest rate, fees, and terms you must qualify for based on your credit score, debt levels, and income.
When you submit an application, the lender will pull a credit report to assess your credit history and credit score. The loan will also require proof of income (unless you are using the balance transfer option).
Having fair to poor credit could mean you only qualify for a personal loan with higher interest rates and loan fees, which will severely limit your savings. Any late payments in the last 12 months will likely disqualify you for a debt consolidation loan or raise the interest rate and terms to levels that negate the benefit of using a loan to consolidate your high-interest debt.
What Debts Can You Pay Off with a Debt Consolidation Loan?
A debt consolidation loan is a personal loan that gives you more freedom on how you use the proceeds. These types of loans can be used to consolidate high-interest credit card debts, pay off past-due medical bills, personal loans, payday loans, student loans, or auto debt. You may also pay off past due tax debts which may protect you from bank account or property seizures, buying you time to further restructure your finances.
What Types of Loan Options are Available for Debt Consolidation?
The most common types of loan options to consolidate debt into a single loan include personal loans, a balance transfer card program offered through a credit card company, and cash-out home equity loans or a home equity line of credit or HELOC. You should carefully consider your short-term and long-term financial goals when considering any type of loan to consolidate debt.
Debt consolidation personal loans do not require collateral, meaning they are unsecured loans. Online lenders specializing in debt consolidation can often provide a high enough amount to transfer all outstanding balances to the new loan. Because the loan does not require any security, you could pay higher rates of interest and high initial fees, which will impact the amount you save.
Credit card balance transfers are another way to consolidate debt. Credit card issuers offer attractive short-term, zero percent interest rate offers to attract new customers, however, you must qualify for a new low-interest credit card offering a promotional rate or short-term zero percent interest rate. The most significant considerations are the balance transfer fees, the promotional interest rate’s length, and the variable or permanent interest rate after the promotion ends. Balance transfer offers could be as low as zero percent interest for up to 18 months.
It can be challenging to secure a new credit card with a substantial credit line when you already have high levels of credit card debt. Therefore, balance transfers are best for moving small outstanding debt balances that you can pay off before the promotional rate ends.
Home equity loans or home equity lines of credit are another popular way to consolidate debt. To qualify, you must own a home with enough equity and have good enough credit to secure the loan. This type of secured loan uses your home as collateral, typically qualifying you for a low-interest rate. However, the fees are higher than any other option, it takes up to 60 days to close the loan, and you could lose your home if your financial situation deteriorates.
How Will a Debt Consolidation Loan Affect Your Credit?
Credit reports gather information from lenders regarding your use of credit. FICO and other credit scoring companies take the information found on your credit report to calculate your three-digit credit score. Scores extend from 300 to 850, with higher scores demonstrating more responsible handling of credit.
Credit scoring companies use five primary factors to tabulate that score.
- Payment history on credit accounts
- Credit Utilization Ratio, which is your credit balances in relation to your credit limit
- New credit
- Mix of credit
- Length of credit history.
Debt consolidation loans can free up revolving credit lines, lowering your credit utilization rate, which can quickly raise your score even though the total amount of debt remains the same. The caveat is that if you add new charges to the credit cards you just paid off, you could wind up in worse financial shape and a much lower credit score.
How Do I Find the Best Debt Consolidation Loan?
Traditional lenders and online companies offer debt consolidation loans. Some debt consolidation lenders allow you to compare potential loans across multiple lenders without affecting your credit score.
The interest rate, fees charged, and loan term are the most essential elements of a debt consolidation loan. Before applying, review your credit and your budget to know what interest rate, fees, and terms you need before it makes sense to consolidate your debt.
How Much Can You Save With a Debt Consolidation Loan?
According to Valuepenguin.com, the average interest rate for an unsecured debt consolidation loan is $18.56%, with rates ranging from 6.67% to over 36%. The rate you can receive will directly affect the amount you can save. Debt consolidation lenders primarily use your credit score to determine their offer. Consumers with credit scores above 680 can expect to pay between 6.67% and 28.33%. Lower scores below 639 could pay as much as 36%, limiting the amount you can save with a debt consolidation loan.
In addition to interest rates, most lenders charge loan fees such as an origination fee, application fee, closing costs, or prepayment penalties. Fees charged for a home equity loan or home equity line of credit may also include appraisal and inspection fees, and attorney costs, which can add up to a few thousand dollars. The application fees and origination fees for unsecured debt consolidation loans typically range from 1 to 10%.
The last factor that determines your savings is the loan term. The longer you make payments on the loan, the more you pay in interest. Most unsecured consolidation loans have a maximum duration of seven years, which is substantially less time than making the minimum payment on credit card debt. The downside of a shorter-term is it may require a higher monthly payment you struggle to pay. If you are unable to pay on time, late fees assessed may further negate your savings and further damage your credit score.
What is The Process for Getting a Debt Consolidation Loan?
Online lenders have changed the process of securing debt consolidation loans. Today, you can apply online, get a decision in minutes, submit the required paperwork remotely, and receive funds within a few days. The simplification of the online process and the increased number of lenders targeting debt consolidation have made it much easier to apply and get approved for a loan.
Debt consolidation loans do not require you to enroll in a program or follow specific rules. Some lenders will pay off your creditors with the proceeds. Other companies release the funds to you, and you decide which debts to transfer to the loan, giving you more flexibility than many debt-relief options.
That being said, a debt consolidation loan does not address any money management issues that created the overwhelming levels of debt you now face. If you do not manage these before getting a new loan, you could wind up adding more debt on your newly paid-off credit cards and end up in worse financial shape than before the loan.
When is a Debt Consolidation Program the Right Option for Debt Relief?
A debt consolidation program could be the best choice if you have a solid credit score and a reliable income. The stronger your financial position, the best rate, and terms a lender will offer, and the more you will save. Consolidation loans are typically best for consumers with good to excellent credit and multiple debts.
When Should You Avoid a Debt Consolidation Loan?
Sporadic income, a low credit score, or too much debt for your earnings can result in less optimal terms. You might qualify for the loan but find the offer includes interest higher than the debt you want to transfer. You also could face high loan fees and a shorter loan term that would raise your monthly payment beyond what you can reasonably expect to pay.
Large current debt levels make it challenging to have a high credit score because it typically means you also have high credit utilization, which accounts for 30% of your overall score. So, while you might be able to locate a lender to approve the loan, the terms may not save you money.
What Are Your Debt Relief Options if You Cannot Qualify for A Debt Consolidation Loan?
If you cannot qualify for a debt loan that will improve your finances, other debt-relief options may be more suitable.
A Debt Management Program (DMP) offered through a non-profit credit counseling agency could be the best option if you earn enough to repay creditors in full, with interest, within five years. The process starts with an evaluation of your income and household expenses, and a payment schedule is created that allows you to pay back your creditors in 5 years or less with interest. Once enrolled, your credit counselor will contact your creditors and request waived fees and penalties and attempt to lower the interest rate on your debt to save you money. You make a single payment to the credit counseling company each month, and the company, in turn, makes your monthly credit card payments to your creditors while you are in the debt management program.
Credit Counseling requires you to show sufficient income to pay your debts in full, plus interest in five years or less, and therefore, is best suited for people with a reliable income source and a manageable amount of debt. In addition to paying back your creditors in full, you must also complete an approved financial education course provided by your credit counseling agency as part of the debt management plan. Credit counseling is not suitable for people who have experienced some type of financial hardship, or who are experiencing a reduction or loss of income. For those with reduced income, financial hardships, or high debt amounts, debt settlement may be a better option to consider.
A Debt Settlement Program, also allows you to make a single monthly payment to eliminate debt. However, the process could allow you to pay less than the full balance owed to creditors and become debt-free in two to four years. The process starts with a free financial consultation with a professional debt arbitrator who can evaluate your current income and expenses and will develop an affordable payment plan designed to reduce the amount you are currently paying each month to service your high-interest credit card debt.
Once qualified and enrolled in a debt settlement program, you make monthly payments into a dedicated Program Savings Account which you own and control. For your protection, the debt settlement company cannot withdraw funds from this account with your approval. The balance in this account will be used to pay your creditors once a settlement has been reached with your creditors and agreed to by you. The fees paid to your settlement company will also be distributed from this account.
When you have enough in the account to make a lump sum payment or sufficient funds to complete a term settlement agreement, a professional debt negotiator will negotiate a lower payoff with your creditors, potentially saving you thousands of dollars. Debt settlement companies maintain relationships with creditors, debt collectors, and debt buyers and work together to their mutual benefit and the benefit of their clients. If you have experienced a financial hardship but have a steady income and the ability to pay back some of your debt, a debt settlement program can be an effective strategy to reduce or eliminate your unsecured debt.
If you do not make enough money to pay all your debts or at least pay a portion of your debt back to your creditors, you may need to consider filing for bankruptcy protection. Under Chapter 7 Bankruptcy, all your qualifying debts can be dismissed, but you may have to sell assets such as your home or automobile. A Chapter 13 Bankruptcy allows you to pay back some of your debts while keeping most of your assets. Either way, filing for bankruptcy protection with severely damage your credit and your credit score will suffer for years as the bankruptcy is reported on your credit report for up to 10 years.
- When is a debt consolidation loan a great option?
A debt consolidation loan could be a good option if you can secure a lower interest rate and afford the often-higher monthly payments. However, transferring debts to a new loan and then adding more charges to your credit cards could be detrimental to your finances. A debt consolidation loan does not address the underlying reason for high levels of debt.
- Will a debt consolidation loan hurt my credit?
In most cases, a debt consolidation loan does not hurt your credit, but adding additional credit inquiries, new credit accounts and lowering the average age of your credit accounts can lower your score. It could also help your credit score because you transfer balances from a revolving line of credit into a fixed-rate loan, which improves your utilization ratio. However, if you begin charging purchases on your credit cards again, it will damage your credit score because your overall debt levels will rise.
- How is a debt consolidation loan and a personal loan different?
Most debt consolidation loans ARE personal loans that you use to consolidate debts, with the exception of secured loans like home equity loans or home equity lines of credit.
- Should I utilize a debt consolidation loan to pay off my credit card debt?
A debt consolidation loan can transfer your debt from high-interest credit card accounts to a single loan. Before agreeing to a new loan, consider the interest rate, loan fees, loan term, and the monthly payment. Each of these factors will determine how much money you will save.
- Can I keep my credit card accounts open after debt consolidation?
A debt consolidation loan does not require you to close any accounts. However, you might benefit from closing other credit accounts if you struggle with the temptation to make additional charges on those accounts.
- Could I qualify for a debt consolidation loan if I have bad credit?
Debt consolidation loans are available to consumers with varying levels of credit. The question becomes, should you get a debt consolidation loan if you have bad credit. In many cases, the interest and loan fees could cost more than you currently pay. You must consider the interest rate, fees, loan term, and the monthly payment amount to decide if the loan will improve your finances.