What is a Debt Consolidation Loan?
Debt consolidation is combining bills from multiple sources – typically 4-5 credit cards – and using one loan to pay off all the bills. The immediate benefit should be lower monthly payments and a lower interest rate.
Debt consolidation loans are a way to erase a lot of complexity in your life — while saving some money along the way.
That stack of bills on the table? What if it was just one envelope? And what if writing just one check a month suddenly saved you more than $1,000 each month?
That’s the essence of a debt consolidation loan. It uses one large loan to pay off the combined balance of credit card debt and small loans. No more fumbling through 8-10 bills to determine when its due and what the minimum payment is.
Debt consolidation loans are generally used to eradicate maxed-out credit card balances, which have become an American epidemic. According to Federal Reserve’s monthly Consumer Credit report, the U.S. credit card debt hit $1.02-trillion in June 2017, surpassing the previous high of $981.8-billion, set just before the financial crisis of 2007.
Debt consolidation loans provide relief. Oh, and you have space to eat at the kitchen table again.
How a Debt Consolidation Loan Works?
In the summer of 2017, a consumer with a credit score between 630 and 690 was eligible for a $20,000 debt consolidation loan over three years at rates between 13% and 20%.
The rates make it all work. By contrast, interest on a credit card with that kind of credit score could be in the 25%-36% range.
A debt consolidation loan should have a lower interest rate than credit card debt — sometimes considerably lower — so your monthly payment is reduced.
Keeping track of multiple payments to multiple creditors can be a dizzying exercise. Imagine the convenience of making one monthly payment to a single lender.
It almost seems too good to be true, particularly if you get a favorable interest rate, so it’s an option well worth investigating.
How to Get a Debt Consolidation Loan
Taking stress out of your financial life seems like a great idea. Reducing monthly payments to a single source sounds good to almost anyone in dire need.
But be careful. It works only if the debt consolidation loan reduces the interest rate for your debts, in addition to cutting back the amount you pay each month. So, it’s important to be organized and have precise financial records.
Here are some steps to follow when you’re studying whether to get a debt consolidation loan:
- Make a list of the debts you want to consolidate.
- Write down the total amount owed, the monthly payment due and the interest rate paid.
- Now add the total amount owed on all debts. Put that figure in one column. That’s how much you need to borrow for a debt consolidation loan.
- For comparison purposes, add the monthly payments you currently make for each debt. Put that number in another column.
- Go to a bank, credit union or online lender to ask for a debt consolidation loan (occasionally referred to as a personal loan) to cover the total amount owed. Ask about the monthly payment figure and the interest rate charges.
- Do a comparison between what you’re currently paying each month and what you would pay with a debt consolidation loan.
Bottom line: Your new monthly payment and interest rate should be lower than the total you are currently paying. If it’s not, you could negotiate with the lender to lower both rates. Usually, banks and credit unions recognize good customers and will work to reduce those rates.
Debt Consolidation Loan Example
It’s hard to compare situations because every debt scenario has different layers and complications, but here’s an example of how a debt consolidation loan could work.
Imagine you owe $5,000 on a credit card with an interest rate (APR) of 18.9% and you are paying $200 a month toward the debt.
You also owe $2,000 a month on a credit card with a 15.9% APR and pay $150 a month on that one.
Now it’s starting to mount. You owe $15,000 on a car loan with a 6.5% APR. You are paying $355 a month for that
There’s also a $5,000 debt on the braces for your 12-year-old son. His smile is well worth the 9.0% APR, which means you are paying $150 per month.
Your total debt: $27,000. The average of all those interest rates is 9.96%. You are paying $855 a month.
By continuing to attack those bills separately, it would require 40 months to pay them off. You would pay $4,722 in interest.
Now imagine getting a debt consolidation loan for $27,000 with an interest rate of 6.99% It would take you 38 months to pay it off. You would pay $3,128 in interest.
Under this scenario, the debt consolidation loan would save you $1,594.
Who wouldn’t want that? But remember that hypothetical 6.99% interest rate? That’s a rate that is given to low-risk borrowers. So that brings up the benefit of a good credit score.
The average APR on a personal loan in August 2017 was 9.76%, according to the Federal Reserve. The average credit score was 685. To receive our hypothetical 6.99% APR, your credit score would need to range somewhere in the mid-to-high 700s.
These figures are not absolute by any means. Lending options exist everywhere. Some work better than others. To avoid confusion — while helping with the number-crunching and arriving at a spot where you’ll actually save money — it’s helpful to contact a nonprofit credit counseling agency for advice.
Debt Consolidation Loan Companies and Costs
There’s more than the interest rate to consider when seeking a debt consolidation loan. There are closing fees, service fees, pay-off dates and other “fine-print’’ charges. Here are the three primary options for where to get a debt consolidation loan. Remember, as with all lending institutions, the rates will vary.
- Credit Unions: The country’s largest credit union is Navy Federal. In August of 2017, its lowest APRs went from 6.99% for a 36-month loan to 14.45% for loans of 60 months or longer.
- Banks: Wells Fargo is typical, offering loan amounts from $3,000 to $100,000. The APR, of course, depends on your credit worthiness.
- Online Lenders: APRs range from low single digits to 36%. Earnest, one of the largest online institutions, has APRs starting at 5.25%.
There’s an online option called “peer-to-peer lending,’’ where companies allow investors to lend directly to consumers. Lending Club offers loans up to $40,000 and charges borrowers an origination fee of 1% to 5%, depending on the credit risk. The average APR for Lending Club loans in July of 2017 was 15% and the lowest APR was 5.99%.
The average APR on credit cards in June 2017 was 16.15%, but many consumers have a much higher rate. If most of your debt is credit cards, you’re very likely to come out ahead with a debt consolidation program.
An added benefit, besides simplifying the monthly bill-paying routine, is a big boost in your credit score. That’s what happens when you pay off credit cards in one swoop. Remember, 30% of your score is based on how much credit you are utilizing on your cards. According to one study, the average credit score increased 21 points within three months of getting a debt consolidation loan.
You should always remember, though, that debt consolidations loans don’t address what might be a symptom of your financial problems. When that stack of bills suddenly goes away, it could bring a false sense of security. The real issue is solving the spending patterns that got you in the financial hole. Debt consolidation loans can be useful tools, but they aren’t the be-all, end-all solution.
Unsecured Loans vs. Secured Loans
Unsecured Loans – These are loans where the borrower is not required to put up any collateral, which is a catch-all term for assets that have value like a home, car or piece of property.
For instance, if you want a mortgage, the house you purchase is the collateral. If you default on the loan, the lending company can seize the house and leave you out on the street.
It’s the same with a car loan. If you stop paying, the Repo (repossession) Man will hitch it up to a tow truck and take it away.
An unsecured loan doesn’t carry those risks. You pledge to repay it based on your existing financial resources and creditworthiness. The most common unsecured loans are credit cards or student loans.
Not paying your monthly bill will lead to all sorts of financial headaches – mainly damage to your credit score – but you don’t have to worry about Visa or American Express or the federal government actually repossessing anything you own because you didn’t repay credit card or student loan debt.
Secured Loans – These are loans that require collateral. You pledge to pay off the loan, and if you don’t the lender can take the asset.
With a mortgage, a finance company or bank will hold the deed or title until the loan has been paid in full, including interest and applicable fees. Other assets like personal property, stocks and bonds are sometimes included as collateral in order to secure the loan.
It’s obviously preferable to not have to risk losing your house or car, but that’s usually the only way a lender won’t gouge you with high interest rates or refuse to loan a large amount of money. The advantage is secured loans usually offer lower interest rates and longer repayment terms, and they are not just for purchasing new items. Secured loans can also be home equity loans or home equity lines of credit.
Types of Debt Consolidation Loans
Not all debt consolidations loans are created alike. There are several options, depending on your financial situation.
Unsecured Personal Loan
Having a lending institution or person hand you a chunk of money with no collateral required is a relatively low-risk way to consolidate debt, but it has pitfalls.
Such loans are usually obtained from banks, credit unions or online lenders, though friends are family can also be sources.
Credit unions are a good place to start shopping for a personal loan since they usually offer the lowest interest rates, though banks and online lenders also offer competitive rates and repayment terms.
As for family or friends, the rates and terms all depend on what the two parties are comfortable with. But it obviously makes little sense to borrow $5,000 from your father-in-law at 5% interest when the credit union is offering 3.6%.
Borrowing from family or friends also runs the risk of ruining the relationship if you have trouble repaying the loan. With lending institutions, there is no personal relationship to ruin. It’s all business.
The pros of getting an unsecured loan are they have a fixed monthly rate and payment period. The cons are that you must have excellent credit to get the best rates, and there is usually an origination fee.
Interest rates can top out at 36% for online lenders and 18% at federal credit unions. Lenders typically don’t charge fees if you pay off the loan early, but the upfront origination fees range from
The bottom line is unsecured personal loans are a good way to consolidate debt, but you should shop around before getting one.
CD/Savings Secured Loan
This is ideal for people with a lot of money in the bank but a bad credit score. That sounds contradictory, but it happens.
CDs are certificates of deposit. Instead of keeping money in a standard checking or savings account, you agree to leave it alone for a set length of time during which you can’t access it without paying a penalty. The advantage is you are paid a higher interest rate.
With a CD/savings secured loan, you use that asset as collateral. Such loans are usually inexpensive and easy to qualify for, especially if you are using the same bank where your savings are kept.
The bank has low risk because it can liquidate your CD/savings account if you fail to pay. But if you pay on time, your CD/savings account keeps earning interest as if it’s never been touched.
Your credit score will also improve because you are paying off a loan. But sometimes it makes more sense to simply use your savings or a CD to pay your debts.
It all depends whether the penalty for early withdrawal would be higher than the cost of interest on a CD or savings account loan.
For example, let’s say you have $10,000 in a three-year CD at 1.5% interest and you need $5,000 to pay off a credit card. If you withdraw $5,000 from the CD, after penalties and lost interest, it would cost you more than $60 in lost interest the first six months.
If you take out a six-month CD-secured loan for $5,000 at 3% interest, it would cost you $44 in interest. So before you consolidate your debt using a CD/savings secured loan, get out a calculator and crunch the numbers. You might be better off just withdrawing the money and paying off your debt.
These are loans from employer-sponsored retirement accounts. You know, the money automatically withdrawn from your paycheck that your employer contributes to.
It’s a great way to prepare for your golden years. Messing with it is a great way to have a lower standard of living in those years.
You’re forfeiting potential gains from your investments in the stock market. The borrowed funds are taxed twice. You’re contributing less to your retirement plan because a portion of new contributions goes toward paying off the loan.
The loans are usually for five years, but if you cease working they are due in 60 days. If you can’t repay it, you pay tax on the outstanding amount and incur a 10% early withdrawal penalty until you reach age 59½.
On the plus side, the loans are easy to get since you are borrowing your own money. That’s assuming your employer allows 401k loans, and some don’t.
And the interest rates are far cheaper than what credit cards charge. The loan also won’t show up on your credit report, so defaulting won’t affect your credit score.
But considering all the risks and penalties, it’s best to look at a 401k loan as a last resort.
Balance Transfer Loan
You take your current credit card balances and transfer them to a new credit card, one with zero or a low introductory interest rate. You will save money in the short term and consolidate the balance, but there are pitfalls. There’s a balance transfer fee (usually from 1% to 5%). Be careful of continuing to use the original credit cards (if they aren’t closed out). And the No. 1 pitfall … READ THE FINE PRINT. The introductory interest rate (maybe 0%) will generally expire in 12-18 months. After that, the rates escalate to levels even higher than the original credit card rate. For example, if you’re paying 24.99% APR on $10,000 in credit card debt, that will cost you a whopping $12,495 in interest over five years.
Home Equity Loan
You take out a loan against your home and use the money to pay off your credit card debt. Equity is the amount your home is worth minus the amount you owe on mortgage (Example: $200,000 value minus $100,000 remaining on the mortgage equals $100,000 in home equity). Remember that a home equity loan is secured by … your home. So, if you can’t make the payments, you could lose your home. Be careful! Also pay close attention to the repayment schedule. If an $800 monthly credit-card loan payment becomes a $500 home-equity loan payment, look a little closer. With home-equity loans, there are sometimes 15-year or 30-year repayment schedules, so in the long term, you could be paying a lot more than the original debt.
No New Loan
Through nonprofit credit counseling agencies, you could get many of the benefits of debt consolidations without the risks. Counselors can find the plan best for you and the best solution could be a debt management program, bankruptcy or a referral to other agencies that can help with your situation.