What you’ve just read could be a commercial for Debt Consolidation Loans, but don’t worry, we’re not here to say they are the ideal tool for digging out of a financial hole.
If the numbers aren’t right, you’d be foolish to pursue credit consolidation. To find the best strategy, you’ll need a calculator, and then you need to answer honestly the question at the top of this story.
Are you tired of staring at a stack of bills?
If the answer is no, you are probably too rich to worry about such things or you’re the type person who inventories their sock drawer every month. There’s nothing wrong with that. It’s just that most people prefer less complexity in their lives.
What is a Debt Consolidation Loan?
A debt consolidation loan is using one large loan to pay off the combined balance of smaller loans and credit cards. It’s taking a lot of small debts and condensing them into one larger, but more manageable debt.
Most debt consolidation loans are used to address maxed-out credit card balances, which are growing rapidly in the U.S. Credit card debt grew to $979 billion at the end of 2016 and is expected to pass $1 trillion in 2017.
If it does, it will surpass the previous high of $981.8 billion set before the financial crisis of 2007.
Many consumers turn to debt consolidation loans as a debt-relief option for their credit card accounts. In March of 2017, a consumer with a credit score between 630 and 690, could get a $20,000 debt consolidation loan over three years at rates as low as 13%-20%.
A debt consolidation loan should have a lower interest rate than your other debts. When done correctly, it should reduce the monthly payment. In addition, you have the convenience of making one monthly payment to a single lender instead of multiple payments to multiple creditors.
How A Debt Consolidation Loan Works
Keeping track of monthly bills isn’t necessarily complex, but it can be a pain in the neck. A debt consolidation loan does what the name implies. You get a lump of money to pay off all those separate debts, and then you make a single payment each month on the loan.
Hello, Easy Street!
If it sounds too good to be true, grab that calculator and crunch the numbers. The most crucial one is the interest rate on your Debt Consolidation Loan. That will largely determine whether you’ll be saving money or you’re just moving debt around like the deck chairs on the Titanic.
How to Get a Consolidation Loan
A debt consolidation loan can take a lot of the stress out of your financial life by reducing multiple monthly payments to just one payment to a single source.
However, the whole purpose of doing this is to reduce the interest rate you pay on debts as well as the amount you pay every month so it is important that have accurate financial records.
Here is a step-by-step sequence for getting a debt consolidation loan:
- Make a list of the debts you want to consolidate.
- Next to each debt, list the total amount owed, the monthly payment due and the interest rate paid.
- Add the total amount owed on all debts and put that in one column. Now you know how much you need to borrow with a debt consolidation loan.
- Add the monthly payments you currently make for each debt and put that number in another column. That gives you a comparison number for your debt consolidation loan.
- The next step is to approach a bank, credit union or online lending source and ask for a debt consolidation loan (sometimes referred to as a personal loan) that covers the total amount owed. Ask how much the monthly payment will be and what interest rate charges are.
- Finally, do a comparison between what you currently pay each month and what you would pay with a debt consolidation loan.
Your new monthly payment and interest rate should be lower than the total you were paying. If not, try negotiating with your lender to lower both rates. If you’ve been a good customer at that bank or credit union, they may take that into consideration and reduce your rates.
Debt Consolidation Loan Example
No two consumers are alike when it comes to debt, but here’s a typical scenario:
You owe $5,000 on a credit card that has an interest rate (APR) of 18.9% and are paying $200 a month toward the debt.
You owe $2,000 a month of a credit card with a 15.9% APR and are paying $150 a month.
You owe $15,000 on a car loan with a 6.5% APR and are paying $355 a month.
You owe $5,000 on the braces you had to get for your 11-year-old daughter. Her new smile carries a 9.0% APR and you’re paying $150 month for it.
In total, you are paying $855 a month on a $27,000 debt. The average of all those interest rates is 9.96%.
Now suppose you get a Debt Consolidation Loan for $27,000 with an interest rate of 6.99%. It would take you 38 months to pay if off, and you’d have $3,128 in interest charges.
If you continued paying those bills separately, it would take 40 months to pay them off and you’d pay $4,722 in interest. So a Debt Consolidation Loan would save you $1,594.
That hypothetical looks good, but it could happen in the real world only if you have a good credit score. That’s because the best interest rates – like the 6.99 APR in our example – go to low-risk borrowers.
Average Interest Rate
The average APR on a personal loan at the start of 2016 was 9.66%, according the Federal Reserve. The average credit score was 687. So to get our hypothetical 6.99% APR, your credit score would need to be somewhere in the mid-to-high 700s.
But remember, we’re talking about a hypothetical. There are countless lenders eager to show you an array of loan options that might work for you. Crunching all those numbers to see if you’ll actually save money can get confusing, so you might consider contacting a credit counseling agency for advice.
Debt Consolidation Loan Companies and Costs
You not only have to consider the APR, but also closing fees, service fees, pay-off dates and other fine-print charges. As to where you can get a Debt Consolidation Loan, there are three primary options.
- Credit Unions. As with all lending institutions, rates will vary. The country’s largest credit union is Navy Federal. As of April of 2016, its lowest APRs went from 10.49% for a 36-month loan to 14.25% for loans of 60 months or longer.
- Banks. Wells Fargo is typical, offering loan amounts from $3,000 to $100,000. The APR depends on your credit worthiness.
- Online lenders. APRs range from low single digits to 36%. Earnest is one of the largest online institutions, and its APRs start at 5.25%.
An online off-shoot is peer-to-peer lending, where a company lets investors lend directly to customers. Lending Club offers loans up to $40,000 and charges borrowers an origination fee of 1% to 5% depending on the credit risk. According to a company survey, the average APR for loans in 2015 was 14.3%.
The median APR on credit cards in 2015 was 13.7%, meaning 50 percent of consumers are paying more in monthly interest. In many cases, much more. If the bulk of your debt is credit cards, you’re likely to come out ahead with a debt consolidation program.
Besides simplifying your monthly bill-paying routine, paying off credit cards in one swoop will boost your credit score. That’s because 30% of your score is based on how much credit you are utilizing on your cards. One study showed the average credit score increased 21 points within three months of getting a Debt Consolidation Loan.
That’s a good selling point, but the alluring package of a Debt Consolidation Loan should come with a Surgeon General’s Warning:
“This Loan Can Be Hazardous to Your Financial Health If Not Properly Used.”
A Debt Consolidation Loan does not wipe out your debt, but the instant relief of not facing that stack of bills can make it feel that way. If you don’t change the spending patterns that got you in the hole, you might end up in a financial chasm that only bankruptcy can solve.
So when you hear what sounds like a commercial for Debt Consolidation Loans, be open-minded but cautious. They can indeed put you on the path to Easier Street, but they can also lead you down a dark alley.
Balance Transfer Debt Consolidation Loans
A balance transfer debt consolidation loan is where you take your credit card balances and transfer them to a new credit card. Often, consumers will transfer their balances onto a credit card that has a low introductory interest rate. This can save you money in the short term and help you consolidate your balances. However, you need to be aware of the following pitfalls associated with transferring your credit card balances from one card to the next.
- If you don’t close your original credit cards, you may continue to use them. Maxing out your balance transfer card and your original credit cards doubles your debt problem and may put you on a slippery slope to bankruptcy.
- Typically, you will pay a balance transfer fee when you transfer your credit card debt from card to another. Fees can range from 1-5%. If you have sizable debt, this can be a substantial sum of money ($1000 on $20,000 in credit card debt).
- The introductory interest rate, which may be as low as 1% or 0%, will expire (typically in 6 months or 1 year: read the fine print). After that, your rates may be even higher than your original credit card interest rate. Remember that paying 24.99% APR on $10,000 in credit card debt will cost you $12,495 in interest over 5 years. That’s more than the original debt.
Another way that consumers consolidate their credit card debt is through a home equity debt consolidation loan. This is where you take out a loan against your home and use the money to pay off your credit cards. Before taking out a home equity debt consolidation loan, it is important to consider the following:
- Do you have home equity? Many people lost 20-50% of their home equity during the housing crisis and recession. You may be one of them. Use real estate websites like Zillow.com and Trulia.com to assess whether or not you have enough equity in your home to qualify for a home equity loan.
- Remember that a home equity loan is secured by your home. If you cannot make the payments, you can lose the roof over you head. It is important to pursue other options before putting your house at risk.
- What is the repayment schedule? You may be delighted to see $800 in monthly credit card payments reduced to $500 with a home equity loan, but how long will you be making these payments? Some people refinance their home on 15 or 30 year repayment schedules. Even with a low interest rate, you’ll likely be paying double your original debt if you draw the payments over a long repayment schedule.
- If you do not close your original credit card accounts, you run the risk of adding to your credit card debt after you’ve taken out a home equity loan, potentially doubling your debt.
- There are hefty closing costs and monthly PMI fees that may make a home equity loan significantly more expensive than you think.
Debt Consolidation Alternative: Consolidate Your Payments without a New Loan
What if you could lower your interest rates and have the convenience of one monthly payment, without taking out a new loan? Through a nonprofit credit counseling agency like InCharge, you can have many of the benefits of debt consolidation without the risks. Additionally, you gain access to a counselor who can help you build a road map to the financial future you deserve.
Debt Consolidation Without Ruining Your Credit
Start free nonprofit credit counseling today. We’ll help you identify the root cause of your financial problems, create a budget that finds savings in several categories, and recommend a debt relief solution based on your personal finances situation. One solution that may be recommended is a debt management program. We may also recommend bankruptcy or refer you to other nonprofits who can help you improve your financial stability. If you’d prefer to speak with a counselor call the number on the right.
(NA)(ND) Average Credit Scores by State. Retrieved from http://www.governing.com/gov-
(NA)(ND) The Total Cost of Borrowing. Retrieved from https://www.wellsfargo.com/
(Jones, S.)(2016, Jan. 15) Peer-to-Peer Lending Sites: Lending Club vs. Prosper vs. Upstart. Retrieved from http://www.asecurelife.com/