If you have trouble making ends meet, if your stack of monthly bills is covering every inch of the kitchen table, if the money coming in doesn’t come close to the money going out, it would seem like you’ve officially reached the end of your financial rope.
Now some good news: You really haven’t. There’s hope. Your solution could be a debt consolidation loan.
Even if you believe your money situation already has plunged into the abyss, look a little deeper. There are all types of debt consolidation loans, even if you have bad credit.
Sometimes, it’s reckless spending. Sometimes, it’s an unexpected life event, such as a major medical crisis or a bad divorce. Even people who practice financial responsibility can find themselves backed into a corner.
In those dire situations, the ability to consolidate debt can be a life-saver.
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.
A debt consolidation loan should have a lower interest rate than your other 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 2017 was 15% and the lowest APR was 6%.
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
Before moving forward and delving into a variety of loan possibilities, some definitions are in order.
- Unsecured Loans — Loans where there is no physical collateral, supported only by the borrower’s creditworthiness.
- Secured Loans — Loans in which the borrower pledges an asset (such as a car, home or property) as collateral for the loan. That provides security for the lender in case the borrower can’t repay.
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: This typically comes from a bank or credit union, although it could also come from family or friends. Depending on circumstances and competition between lenders, you could get a great rate. If you let the bank take payments from your account automatically, the rate could be even lower. But if you have a spotty credit history with many outstanding debts, this option might not work as well for you.
- CD/Savings Secured Loan: This is a good option for someone with bad credit, but a sizable amount of cash in their bank account (yes, these people actually exist). Borrowing against a CD (certificate of deposit) or your savings account can help you out of an emergency and build up some credit. CDs and savings accounts are tools meant to be left alone for a period of time, so interest can be accrued. If money is withdrawn before the term ends, there’s generally a penalty. But you can tap some capital by taking out a loan against the CD or savings account. This method only makes sense if the penalty for early withdrawal would be higher than the cost of interest on a CD/savings account loan. It works well for consumers whose only other option is taking an unsecured debt, such as a credit card with high interest rates. 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 your credit-card debt, then consolidate it through a single CD loan. If you withdraw $5,000 from the CD, after penalties and lost interest, it would cost you more than $60 in the first six months (the rates are low because they are fully secured by your own money). If you take out a six-month CD-secured loan for $5,000 at 3% interest, it would cost only $44 in interest. And if you borrowed $5,000 through another loan, the monthly payments might be upwards of $800. Repaying a CD loan on time establishes good credit and an effective way to pay off high-interest debt. CD loans are cheaper because lenders have collateral they can seize if you can’t repay, making it less risky than any unsecured loan. In fact, it’s completely risk-less for the lender because they earn an interest spread on the customer’s own money.
- 401(k) Loan: It’s not advisable to take a loan from an employer-sponsored retirement account because it could significantly impact your retirement. There are some benefits, such as this loan won’t be counted on your credit report and you are borrowing money from yourself. It’s also a lower interest rate than an unsecured loan. But there are potentially huge drawbacks. If you can’t repay, you’ll owe a hefty penalty plus taxes on the unpaid balance, putting you deeper in debt. The 401(k) loans are typically due in five years. If you lose your job or quit, thought, they are due in 60 days. So go into this loan possibility with eyes wide open.
- 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 six months to a year. 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.
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