How To Get The Lowest Interest Rate On A Debt Consolidation Loan

Lowest Interest Rate

Debt consolidation is taking out one loan to pay off many debts. It’s a common get-out-of-trouble solution for consumers, especially those with overwhelming credit card debt. It simplifies bill-paying and, if done correctly, should reduce monthly payments.

The problem is that interest rates on debt consolidation loans vary wildly, ranging from as low as 5% to as high as 36%. Consumers using debt consolidation loans to pay off credit cards say they pay an average of 20% interest on those cards.

Whatever method you choose in consolidating your debt needs to include an interest rate that is half, or less, of that.

So how do you get that down to a single-digit interest rate that helps you pay off debt faster?

Improve your credit score!

Let’s say you need a $10,000 debt consolidation loan. Look at the difference in rates and monthly payments on a 3-year loan, based on credit scores.

720 score — $299 mo. payment at 5% interest. Total interest paid: $789.

670 score — $318 mo. payment at 9% interest. Total interest paid: $1448.

620 score — $337 mo. payment at 13.1% interest. Total interest paid: $2,147.

Improving your credit score by 50 points saves you $699. Improve your credit score by 100 points and you save $1,358.

Improving your credit score also could make you eligible for a zero-percent interest balance transfer credit card. Generally speaking, you would need a credit score above 700 to qualify for one of these cards.

Steps to Improve Credit Score

The best borrowing rates go to consumers with credit scores 740 or higher. The further down the scale you go, the higher the interest rate you will pay. Anything below 660 is going to mean a high rate, though maybe not as high as the rate for credit cards.

The steps to get a better credit score are manageable, but require discipline.

  • Pay bills on time
  • When possible, pay off balance every month, or at least make minimum payment
  • Set up automatic payments to make sure you don’t miss one
  • Keep credit card balances at less than 30% of your credit limit
  • Don’t sign up for new credit cards
  • Look for mistakes on your credit report

This won’t be easy, but if done effectively, it will raise your credit score and lower the interest rate you pay on a consolidation loan.

Best Ways to Consolidate Debt

There are four major ways to consolidate debt: bank loan; credit card balance transfer; debt management program and personal loan.

Each one has positives and negatives associated with it, so examine them closely. It is important to know about fees or penalties for things like late payments, balance transfers or early pay offs.

Here are the highlights of the four options.

  • Bank Loan — Relatively simple. You borrow enough from the bank to pay off all your debts and negotiate for an interest rate that will help reduce your monthly payments. Now you deal with one lender — the bank.
  • 0% Interest Credit Card Balance Transfer — Many credit cards offer 0% interest for the first year or more. It can be efficient to transfer your debt to a 0% card, but only if you pay off the balance before the introductory period expires.
  • Debt Management Program — Reach out to a reputable, nonprofit credit counseling agency about a debt management plan. The counseling agency works with creditors to reduce your interest rate and monthly payments. You make one monthly payment to the agency, which pays each of your lenders at an agreed upon rate. The debt management plan typically lasts 3-5years. The key is consistency. By committing to the plan and not running up more debt, you can erase your problem.
  • Personal Loan — You have a simple interest rate from a bank or credit union, instead of a variable interest rate that comes with a credit card. You could consider taking a personal loan from a family member or friend, who might give you a really low rate. But don’t take advantage of the situation. Treat it like any business transaction, keep perfect records and pay on time.

There is not a one-size-fits-all strategy here, but there is a universal truth. None of these plans will work if you can’t make your payments or if you string out the process to where you’re paying more than you originally owed. Be smart. Know that the real way out of debt is to change your spending habits and develop a financial game plan where you don’t go beyond your current resources.

Understanding Interest Rates

You have undoubtedly heard the term “interest rate” a million times, but what does it mean in real terms?

Interest is money you pay for the privilege of borrowing. Lets say a bank loans you $1,000 at a 6% annual interest rate. That means youd pay an extra $60 if you pay back the $1,000 at the end of 12 months.

Thats called “simple interest.”

Most loans utilize “compound interest,” where you dont just pay interest on the initial $1,000 loan, you also pay interest on the accumulated interest. The rate that debt grows depends on how often the loan “compounds,” or comes due. With credit cards, its typically once a month.

The bottom line: When you choose debt consolidation, shop around for the lowest interest rate possible.

Zero-Percent Balance Transfers

When you see an offer of 0% interest, it sounds too good to be true, right? But that credit card option is out there — readily available, actually — and could work to your advantage with proper planning.

If you shop around, it’s easy to find a credit card company that offers 0% interest rate on the transfer of an existing credit card balance. These are generally introductory offers, so the interest rate changes, usually in 12-18 months. And that change might be ridiculously high!.

By paying attention, however, you can pay down your debt while the rate is zero. Be sure to read the fine print on zero-percent balance transfers. There could be fees charged.

Credit scores also come into play when applying for 0% credit cards. The average credit score accepted for major 0% cards ranges from 685 (Chase) to 707 (Discover) to 736 (Citi).

Home Equity Loans/Lines of Credit

This is basically a second mortgage. You put up your house as collateral and secure a loan or a line of credit. Interest rates are usually between 3% and 8% with the average rate for a $30,000 loan in 2017 hovering near 5%.

Interest Rates on 401(k) Loan

About 75% of the people with a 401k plan have the option of borrowing against the money in that plan to take care of financial emergencies.

You are borrowing money from your retirement account and repaying with part of your weekly paycheck. You can borrow 50% of the total in your 401k account or $50,000, whichever is smaller.

Interest rates are usually based on the Prime Rate plus 1 or 2%, so a five-year loan would have an interest rate of about 5.5%. But the interest is repaid to the consumers own account, so its not a loss.

Interest Rates on Payday Loans

If the loan business were the weight-loss business, this would be like going to a diet clinic and being handed a bag of doughnuts.

A consumer borrows a small amount of money – usually less than $500 – and pays an extraordinarily high interest rate.

They typically write a post-dated check in the amount they wish to borrow, plus a finance charge. The lender holds onto the check and cashes it on the agreed date, which is usually the consumers next payday.

Most loans are due in two weeks, and research shows 70% of borrowers take out a second payday loan before paying off the first. The finance charge for most payday loans is $15 per $100 borrowed for two weeks. That’s translates to an annual interest rate of 399%.

Repeat – 399%!

A variation of the payday loan is the auto title loan, where the consumer puts up his or her car as collateral. If the borrower cant repay the loan in 30 days – and studies show that 20% cant – they lose their car.

Compare More Than Rates

If you’re comparing the various debt consolidation plans, be certain to investigate more than just the interest rate offered. Some loans carry an early termination fee, others have an initiation fee. These fees, sometimes not so obvious, might wipe out the savings you thought you were getting from a more favorable interest rate.

If you’re looking at 0% interest rate introductory credit card, make sure you can pay it off before the new card’s interest rates kick in or you might have an even bigger problem.

For personal loans, use your common sense. If you have bad credit, the interest rates can be outrageous, so be forewarned.

If your credit score is low (less than 600), you might have trouble qualifying for a loan. There’s always a home equity loan, where you borrow against your home. The risk: If you fail to make payments, you’ll be facing foreclosure.

There’s also a secured loan from a bank or credit union. You must put up a valuable item (such as a car) as collateral. The risk: If you fail to make payments, you’ll lose the collateral.

Before doing anything, it’s always useful to check your credit reports and scores, making sure everything is accurate. Credit reports and scores are the financial bible for lenders and a mistake could cost you thousands in interest rates.

If you consolidate into one credit card, avoid maxing out that card’s credit limit because that harms your credit utilization rate, which is how much debt you’re carrying compared to your total credit limit.

Also know that applying for a new line of credit creates a hard inquiry on your credit report. It can lower the average age of your credit history and thus lower your credit score. A new personal loan shows that you have a high level of outstanding debt.

But adding a personal loan also improves your mix of accounts. By keeping on top of payments, you establish a positive payment history, which should help your credit score.

Drawbacks to Debt Consolidation

There’s risk involved with any method you choose for debt consolidation so do your homework. Here is a look at some of the drawbacks for each plan.

  • Debt Management Program — It always sounds good to take the payments from several credit cards (let’s say a total of $1,000 per month) and reduce it to one lower payment (let’s say, $800 per month). But be careful. Be sure the nonprofit credit counseling agency you choose has a good track record with consumers. They should present you with a plan that lowers your interest rate and monthly payment and eliminates all debt within 3-5 years. If that doesn’t happen, back away.
  • New Lines Of Credit/Second Mortgages — The major problem is that your home is used as collateral and if you miss payments, it could be foreclosed. The other thing to look for is fees for anything and everything the lender can think of. Make them spell out if you’re paying an origination fee, appraisal or any other cost.
  • 0% Interest Rate Credit Cards — The risk is not paying off the debt during the introductory 0% interest rate period (usually 12-18 months). When that period is over, you could be facing interest rates of 18% or higher. You must be disciplined.
  • Personal Loans — Depends on who loans you the money. If it’s a relative or friend, the relationship can sour quickly if you fail to make on-time payments and/or default on the loan. If you get it from a bank or credit union, you will pay a higher interest rate because it’s an unsecured loan, meaning no collateral to back it up.

Personal Loans vs. Debt Consolidation Loans

It’s easy to get confused when considering whether to take out a personal loan or seek a debt consolidation loan.

There are subtle differences.

A personal loan can be used for any expense. It’s granted based on your credit worthiness. With a secured personal loan, there is collateral needed (such as your home or car).

According to Farmers Bank, for a $5,000 unsecured loan with a two-year term, consumers will receive an 11.25% annual percentage rate (or a $224 monthly payment).

According to Bankrate, for a $10,000 secured loan with a three-year term, consumers with excellent to good credit can receive a 4.29% APR or an approximate $297 monthly payment. With fair credit, it shoots up to 10.66% APR, or a $326 monthly payment. With poor credit, if the consumer is still being considered, it hits 25% APR (or a $398 monthly payment).

You could take out a higher loan than needed in order to cover new expenses. Personal loans are high risk, so they will be at a high cost. But when paid in full, they will significantly boost your credit score. There is no consolidation company working on your behalf, so the consumer must have the discipline to use the funds for the debt and not for some other whim that might come along.

A debt consolidation loan is used specifically to pay down your debt. You’re usually working with a consolidation company that uses its experience and contacts to reduce the interest and monthly payment so you can efficiently settle your debt.

It might come with protections from previous lenders, who won’t be able to contact you once the consolidation company has taken over. It will have a high interest rate because it’s a high-risk loan. You are surrendering your flexibility in exchange for total control by the lender.

There are a lot of loan options out there. Dont choose one that will leave you worse off than you began.

Get at least three proposals banks or other lending institutions. If the best offer you can find is a payday loan, dont eat the doughnuts. Instead of a loan, you probably need to completely overhaul your financial life.

Thats why its wise to get a proposal from a nonprofit credit counseling agency like InCharge. Certified counselors can advise you on an overall strategy to get out of debt forever.

Sources

DiGangi, C., (2017, 10 March), 5 Tips for Consolidating Credit Card Debt. Retrieved from https://www.credit.com/debt/5-tips-for-consolidating-credit-card-debt/

Ramsey, D., (2017), The Truth About Debt Consolidation. Retrieved from https://www.daveramsey.com/blog/debt-consolidation-truth

Chough, V., (2017, 6 February), How To Get The Best Debt Consolidation Loan Rates. Retrieved from https://www.credible.com/blog/how-to-get-the-best-debt-consolidation-loan-rates/

NA, (2008, 6 March), How To Get A Low Interest Rate Debt Consolidation Loan. Retrieved from https://www.sapling.com/4589352/interest-rate-debt-consolidation-loan