If you've got lots of debt from various sources, a debt consolidation loan could help you organize your finances and set your future straight. “What is a debt consolidation loan?” you might ask. Well, this post will answer exactly that.
In this post, we'll also cover some of the pros and cons of debt consolidation loans, the different kinds of loans you can get, and help you determine whether a debt consolidation loan is right for you. Let's dive right in.
What Is A Debt Consolidation Loan?
When you were a kid, did you ever buy lego sets that had their legos all organized neatly in the case by color (or type of lego)? If you were like most kids, you had a blast playing with them, but then also had the responsibility of putting them away. When you put them away, did you RE-COLOR CODE them and separate them into different holding containers? Chances are….. no!
You probably just took all the legos (regardless of color) and tossed them into a bucket! This is exactly what consolidation is. The official definition of consolidation is “combining a number of things into a single whole.” By taking all the legos and tossing them into one bucket, you've consolidated your legos.
Debt consolidation, then, is exactly what you might expect. It's when you take many sources of debt of roll them into a single payment. This could be an especially good idea when you can get a loan with a lower rate than the ones you have on your existing debt (credit cards are known to have exorbitant interest rates).
Even if you have manageable amounts of debt, consolidation may be a good idea. Oftentimes your credit card debt will have different loan terms and deadlines than your student loans which will have different conditions than the installment loan for your AC, etc. Debt consolidation could be useful just to reorganize your finances and make things simpler.
The Pros and Cons of Debt Consolidation Loans
There are many different ways you can do debt consolidation (as you'll see in the next section), and each way has its own pros and cons. Still, there are some general advantages and disadvantages of debt consolidation that you need to be aware of before hopping in.
Pros of Debt Consolidation
Here are some of the main benefits of debt consolidation:
- Repay your debt sooner – getting your debt consolidated could put you on the fast track to repaying your debt. This is oftentimes true if you have very high credit card balances and there is no deadline for credit card payments. If you're not on top of them, they could spiral out of control and high-interest debt could drag on for a long time. A consolidation loan has a clear payment schedule with an end to it, and although with a credit card you might have a lower monthyly payment, consolidations could help your finances more in the long run. The sooner you repay your debt the sooner you can start saving towards other goals (like an emergency fund or retirement).
- Make your finances more simple – one of the most frustrating parts of personal finance is the different deadlines and due dates for all the different bills and debt you need to pay. When you consolidate your debt, you can roll 3-5 different payments into a single payment every month. Let's say you had debt from 2 different credit unions, 3 different credit card companies, and medical bills that you and indebted to. A consolidation loan will basically pay off all these and you'll just need to focus on paying off the new loan. The loan amount will also be made very transparent to you and the monthly payments will stay the same throughout the lifetime of the loan.
- Get a lower interest rate – according to creditcards.com, the average interest rate on a credit card is around 16.20%. Meanwhile the average rate on a personal unsecured loans (a popular method of debt consolidation) can go as low as 11%. These rates obviously depend on whether you have a good credit score or not, but gernerally speaking a personal loan will give you lower interest rates than the ones on your credit card debt. If you have a good/decent credit score, you'll likely be able ot take advantage of the lower interest rates that debt consolidation offers.
- Increase your credit score – it's true that typically a debt consolidation loan will decrease your credit score right from the outset. That being said, over the long run you're very likely to see an increase in your credit score. This is because debt consolidation makes it much more likely that you'll make your payments on time. A huge part of your credit score is affected by your payment history, so just hitting your payment deadlines should significantly boost your credit score. On top of this, if you had credit card debt it will all be wiped out. The average balance you have on your credit cards also affects your credit score a great deal so turning all those numbers to 0 will definitely increase your credit score.
Cons of Debt Consolidation
Of course, just like with anything in life, there are advantages and disadvantages to debt consolidation. Here are some of the drawbacks to consider before getting your debt consolidated:
- Won't solve all your financial problems – getting your debt consolidated can make your finances a lot simpler and your payments more straightforward, but you still need to make the payments. If the reason you're in so much debt in the first place is because you live beyond your means, chances are you'll continue to do so even after your debt is consolidated. To truly improve your financial situation, you need to change your financial habits. There's no way around this fact.
- Might have a higher rate than your current debt – if you have a shaky credit history and your credit score isn't great, consolidating your debt MAY result in a higher interest rate than what you're currently paying. Furthermore, the amount you pay each month depends on your loan terms and lenght of the loan. If you take out a consolidated loan for a long time, you may end up lower monthly payments, but still be losing tons of money to interest.
- Might set you back even more if you miss payments – taking out a new loan for debt consolidation is great if you can afford the payments, but if you can't, it's a disatrous idea. Most lenders will charge you a late payments fee or return payment fee if you don't make a payment on time / can't afford the minimum payment. These can add up very quickly if you're not careful. Furthermore, most lenders will report you to the credit bureaus if you're more than 30 days late. If this happens, your credit score will suffer in more and you'll be left in a worse financial position than when you started.
- Might require you to pay upfront costs – some consolidation loans require you to pay some fees upfront. These may include a loan origination fee, balance transfer fees, closing costs, and annual fees. Make sure to read all of the fine print before entering into any consolidation loan agreement. It's best to know exactly what the terms are before rolling all your debt into this one loan.
Different Ways to Get a Debt Consolidation Loan
There isn't just one way to consolidate your debt, and each different way has its own advantages and disadvantages. Here are various ways to get a debt consolidation loan and what's unique about each of them.
Refinance Your Mortgage
If you have money in your mortgage, you could refinance that money out with a home equity loan (or home equity line of credit – HELOC). What this does is give you cash to pay off your debt with.
If you have enough money in your home equity to pay off all your different sources of debt, then technically you've “consolidated” all your debt into your mortgage. Your new interest rate will be whatever interest rate was on your mortgage (typically much lower than something like credit card interest).
One of the biggest advantages of refinancing your mortgage to pay off your debt is that you're much less likely to forget to pay your mortgage than random sources of debt. Another great thing about refinancing your mortgage (aside from the likely lower interest rates) is that you may be able to deduct interest payments on home loans to reduce the amount of tax you need to pay.
Use a Balance Transfer Card
A balance transfer credit card basically lets you shift your high-interest debt into lower-interest debt. Some balance transfer cards even offer 0% APR (annual percentage rate) for the first year or two of shifting over. If you have a good credit score, this could help you significantly reduce the amount of interest you'll pay over the lifetime of your debt.
Something to watch out for with balance transfer cards is that they usually come with a 3% – 5% fee up front. Usually, this will still be less than the existing interest on your credit cards, but still, it's something to be wary of. Also, after transferring your debt over to a different credit card it can be very tempting to run up the debt on your old credit cards (doubling your debt!)
This being said, balance transfer cards are a popular way to consolidate multiple cards into a single account and simplify your debt. They can also substantially reduce the overall cost of your credit card debt.
Take Money Out of Retirement Savings
If you truly don't have any other option, you can consider taking money out of your retirement savings. When you pay off your debt, you are immediately “earning” the interest on it since you'd need to pay that interest had you not paid off your debt. Because of this, only consider dipping into your retirement savings if you have higher interest rates on your debt than the annual interest you think you can make with your retirement fund.
With this method, you won't need a credit check and you're basically getting money for “free”. You might, however, need to pay taxes and penalties for withdrawing money early. Also, some employers won't let you dip into their employer matches to do debt consolidation. Finally, if you can't pay back the debt quickly, you end up permanently reducing the amount of money in your retirement savings.
Ask For a Loan From Your Friends/Family
If you have a rich relative or friend whom you trust, it might be a good idea to ask them for a loan. You can negotiate terms and use the money they loan you to pay off your existing debt.
If you have someone whom you trust this could be an excellent method to consolidate your debt. There will be no credit check PLUS your friend/family member could earn some interest on their money.
This being said, if you screw up, you could REALLY mess up an important relationship. Chances are it will take a long time for them to forgive you, and you probably won't be able to borrow from them ever again. On top of this, any loan payments you make won't be reflected on your record so it won't help your credit score.
Apply For a Personal Loan
A personal loan is different from a loan from a friend/family member. Usually, a personal loan is something you need to pay off relatively quickly (like within a few months' time). If your credit score is good though, you may be able to secure a personal loan with a lower monthly payment and better terms than your current outstanding debts.
This is especially true with credit cards as the high-interest rates from those can usually be consolidated into lower interest debt with a personal loan.
Something to be aware of is that if you ARE going to apply for a personal loan, your credit will get checked. On top of this, with a “clean” credit card, you could let the debt run up unchecked again.
What Is A Debt Consolidation Loan: Recap
A debt consolidation loan is when you take multiple sources of debt and roll them into one single monthly payment with a new loan. There are many ways to do this and some don't require you to get a credit report or credit approval.
Generally speaking, debt consolidation loans will have low rates compared to the existing debt you have which is why they are so popular.
As always, make sure to do your own research before making any financial decisions. That being said, if you have lots of debt from various sources, make sure to check out debt consolidation. It could transform your finances!
Joe DiSanto is the founder of Play Louder! He has built multi-million dollar businesses, produced critically acclaimed documentaries and an Emmy-winning TV show, invested millions in real estate, and semi-retired at age 43. Now, Joe serves as a Fractional CFO for several creative firms and is sharing a lifetime of fiscal know-how via Play Louder, an invaluable resource that helps individuals and business owners increase their net worth and plan better for their future.