Choosing the best debt consolidation method requires you to take several things into consideration. For instance, are you looking for a fixed-rate loan or balance transfer? Or how long do you want to keep the debt consolidated? These are all questions you should be able to answer by the time you’re ready to start your application. Below is a guide that can help you decide which loan or balance transfer method will work best for your situation.
Written by Attorney Curtis Lee.
Updated October 20, 2021
Debt consolidation is a tool many borrowers use to get out of debt. It works by taking two or more debts and combining them into a single debt. Debt consolidation works best when the borrower can also change some of the terms of the debts, such as lowering their interest rates. If the borrower can do this, they’ll not only enjoy fewer debt payments each month but also save money by paying less in interest over the life of the loan. Before we look at debt consolidation loans, let’s first take a look at what debt consolidation is and how it could help you pay off your debts.
Debt Consolidation: The Basics
Debt consolidation is a debt relief tool that combines multiple debts into a new loan. Debt consolidation doesn’t wipe out your debt. Instead, it reduces the number of monthly payments you must make, which makes your debt easier to manage. It also decreases the risk of paying late or missing a loan payment.
There are several ways to consolidate debt. Common methods include:
Personal debt consolidation loans
Credit card balance transfers
Home equity loans or lines of credit
Ideally, when you consolidate your debt, you’ll be able to lower your interest and get a fixed rate. This can save you money over time as you pay off your debt. It can also reduce your monthly debt payment.
Consolidating debt can be a smart money move if you have good financial habits, a sufficient credit score, and multiple unsecured debts. But debt consolidation may not be the best form of debt relief if you can’t be sure you’ll make all your monthly payments. Debt consolidation may also be a bad idea if the costs exceed the benefits. A good example of this is if you can’t get a low enough interest rate in a debt management plan (DMP). Because of monthly fees, you might end up paying more money by consolidating your debt with a DMP than separately paying off each debt.
Unsecured Debt vs. Secured Debt
Most unsecured debts are eligible for debt consolidation. This includes credit card debt, student loans, and medical bills. These debts don’t have any collateral backing them up to protect the creditor if the borrower defaults. In other words, there’s no property for the lender to recover if the borrower can’t pay back their loan. The creditor can sue the borrower and get a judgment from the court to get their money back though. Then the lender can garnish the borrower’s wages. To help offset these risks, creditors will often charge higher interest rates for unsecured loans.
In contrast, a secured debt is a loan that’s connected to property that serves as collateral. Should the borrower fail to make monthly payments on a secured debt, the creditor can repossess the collateral from the borrower. The most common types of secured debts are home mortgages and car loans, with mortgage loans secured by the home and car loans secured by the vehicle. It’s possible to consolidate secured debt, but your options for doing so will be more limited than trying to consolidate unsecured debt.
What’s a Debt Consolidation Loan?
One of the most popular ways to consolidate debt involves using a debt consolidation loan. This is a loan that’s used to pay off two or more other debts. So, instead of multiple original debts, the borrower now has a single debt consolidation loan to pay. Generally speaking, debt consolidation loans have terms that range between 1-10 years. They also tend to allow borrowers to consolidate up to $50,000 in debt.
Even though borrowers can consolidate most types of unsecured debt, it’s most commonly used for credit cards and medical bills. Debt consolidation is particularly popular for paying off multiple credit cards. Unlike credit cards, interest on a debt consolidation loan doesn’t get compounded. Instead, the interest rate usually remains unchanged throughout the life of the debt consolidation loan.
How Does a Debt Consolidation Loan Work?
Borrowers can obtain a debt consolidation loan from various sources. These include banks, credit unions, credit card companies, and online lenders. Each of these institutions will have its own requirements for qualifying for a debt consolidation loan. But most will require that borrowers:
Are at least 18 years old;
Have a good credit score or excellent credit score; and
Provide proof of reliable and sufficient income.
You’ll also need to complete a loan application. This process varies by lender but will include filling out forms and listing your personal information so they can run a credit check on you. They’ll also want you to state your sources of income and current debt obligations. Most lenders will also ask that you provide documentation to prove where you get your income and how much debt you have.
How Do You Choose a Debt Consolidation Loan?
The good news is that there are plenty of debt consolidation loans to choose from. You’ll need to figure out which is best for you. To make this selection process easier, you’ll want to focus on:
Your monthly income
Your existing debts that won’t get consolidated by the debt consolidation loan
Your credit score
Whether you’re applying for a secured or unsecured debt consolidation loan
How long you have to pay off the loan
How large of a loan you need
The loan’s interest rate
These last three factors will play the biggest role in how big your monthly payments are. As important as it is to find the best terms possible, you need to make sure you’ll be able to make the monthly payment. That may mean you need to pay more in interest or accept a slightly higher interest rate to lower your monthly payments.
Also, don’t forget to consider the loan’s costs, such as transaction or origination fees or potential prepayment penalties. A prepayment penalty is a fee you incur to pay off your loan early. These are more common with home mortgages, but some debt consolidation loans have them.
Secured Consolidation Loans
Just like how a “regular” debt can be secured or unsecured, so can a debt consolidation loan. Ideally, you want to get a secured consolidation loan. All else being equal, it’ll offer better terms, like a lower interest rate, larger loan amount, or both.
If you decide to apply for a secured debt consolidation loan, there are two things to keep in mind. First, try to use real estate as collateral. In theory, you can use almost any property of value as collateral. But lenders may have rules about which types of collateral they accept. Besides the greater likelihood of a lender accepting real estate as collateral, using real estate to secure a loan has other advantages.
The value of real estate, unlike other significant assets like a car, boat, or RV, tends to go up over time. Should you default on the loan and your lender repossess your collateral, there’s a smaller chance you’ll end up having to pay a deficiency balance. Lenders know this and loans secured with real property tend to have the lowest rates of interest compared to loans secured with another type of asset. Property like cars and trucks tend to lose value as they age, so lenders will usually charge higher interest rates for loans that use these as collateral. Lenders may also reduce the amount of money they’re willing to loan you.
Second, the application process for a secured loan is a bit more complicated. The lender will ask you to provide more information, such as filling out more forms and getting an appraisal of the property you plan to use as collateral. Despite these potential drawbacks of a secured loan, using collateral might help you get approved for a debt you might not otherwise qualify for, whether it’s because you couldn’t get a cosigner or didn’t meet the lender’s minimum credit score requirements for an unsecured loan.
Pros of Debt Consolidation Loans
For the right borrower, debt consolidation loans have several advantages.
They can decrease your monthly debt payment. This lower monthly payment can come from a lower interest rate, extended loan term, or both.
They can reduce the total amount of money needed to pay off your debts by lowering your interest rate and saving you money in the long run.
They make your monthly payments more manageable. It’s a lot easier to make one payment each month and remember only one due date and payment amount.
They reduce the chances of a missed or late payment. With fewer debt payments to make, it’s easier to remember to make them on time. Late payments can lead to late fees and a lower credit score.
They can help improve your credit score. On-time payments help build a positive credit history as you pay off your debt consolidation loan. It shouldn’t be long before you see a steady improvement in your credit score.
Cons of Debt Consolidation Loans
Despite its benefits, debt consolidation loans aren’t for everyone. They have some disadvantages that could make other debt-relief tools a better option. Here are some of the drawbacks:
Your monthly payment may be higher. If you aren’t able to make your payments and you default on your debt consolidation loan, it’ll set you back on becoming debt-free and it’ll hurt your credit score.
If you can’t get a low enough interest rate, you could end up paying more money in interest for the length of your loan.
Debt consolidation doesn’t wipe out your debt. If your debt is overwhelming, you may want to use other debt management methods, such as bankruptcy or debt settlement.
Consolidation can be expensive if there are transaction or loan fees. These can easily offset the financial advantage of a lower interest rate.
Does Debt Consolidation Affect Your Credit Score?
Yes. If you get a debt consolidation loan and make your payments on time, your credit score should increase. This makes debt consolidation loans a solid option for rebuilding your credit.
But applying for a debt consolidation loan may temporarily reduce your credit score because lenders will make a hard credit inquiry. According to Experian, a hard credit pull will reduce your credit score by about five points. These inquires can stay on your credit report for up to two years. The better your credit, the less the hard pull will negatively affect your credit score.
One of the worst ways a debt consolidation loan can harm your credit score is if you miss a payment. Federal law states that creditors can’t report late payments to credit bureaus (Equifax, TransUnion, and Experian) unless the payment is at least 30 days late. If this happens with your debt consolidation loan, you can expect a significant drop in your credit score. This is because payment history is the single biggest component of your credit score.
Debt Consolidation Loan vs. Balance Transfer Credit Card
One of the easiest and most enticing forms of debt consolidation is a credit card balance transfer. These allow account holders to move credit card balances from one or several credit cards to another card. The new card will usually have great terms, such as a low or 0% introductory interest rate, which usually lasts for 6-18 months.
But balance transfers have some potential drawbacks. First, there’s a transaction fee that ranges from 3%-5%. You’ll pay this fee no matter how quickly you pay off the new credit card account. Second, after the introductory interest rate period ends, you’ll start paying the regular interest, which can be 15% or more.
Using a balance transfer credit card is different from a debt consolidation loan in that it’s usually limited to just consolidating credit card debt. It’s also best if you’re trying to consolidate smaller credit card balances. In contrast, debt consolidation loans are used more often with larger debts, such as those that may exceed your balance transfer credit card’s limits. Also, you usually can’t transfer balances between credit cards from the same bank.
Depending on the debts you’re trying to consolidate, there’s another loan option that acts as a combination of a debt consolidation loan and a credit card balance transfer. Because some car loans and medical bills are payable by credit card, you can use a credit card to pay off these debts. If you can do this with a credit card with a great promotional feature, like a 0% annual percentage rate (APR) on any purchase made during the first year, this is something to consider. In this example, you could end up saving 12 months of interest by consolidating these debts. But you need to be careful doing this.
Once the promotional period ends, this credit card account will turn into high-interest debt when the interest rate goes from 0% to the regular rate. You could be better off paying off your debts separately in the time it takes to pay off the credit card before the promotional interest rate expires. Also, your creditor may charge you a fee to pay your bill using a credit card. Depending on what this fee is, it may not make financial sense to take this approach.
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Debt Consolidation Loan Interest Rates
Interest rates on debt consolidation loans vary based on different factors. But most interest rates range from 6% to 36%. If you have a FICO score of at least 720, you can expect an interest rate on the lower end of this range. If you have bad credit, such as a score below 580, you can expect lenders to either deny your loan request or give you an interest rate so high that it’s not financially worth it.
To give you an idea of what it means to have a FICO score of 720 or more, here’s how Experian breaks down credit score distributions:
Exceptional: 800 to 850. About 20% of people are in this range.
Very Good: 740 to 799. About 25% of people are in this range.
Good: 670 to 739. About 21% of people are in this range.
Fair: 580 to 669. About 18% of people are in this range.
Very Poor: 300 to 579. About 16% of people are in this range.
Another factor that can affect your interest rate is the loan term. All else being equal, the longer you have to pay off your loan, the higher your interest rate.
When you apply for a loan, your lender will also look at your overall creditworthiness. This means looking at your monthly income, existing debt, and debt-to-income ratio. If you want the best credit terms possible, as a rule of thumb, you want this ratio as small as possible. For example, if your monthly debt payments are equal to $3,000 per month and your gross monthly income is $4,000 a month, then your debt-to-income ratio is 75%, which is fairly high.
When looking for a debt consolidation loan, it’s best to shop around with several potential lenders. You’ll have a chance to compare the terms of each of their loans, including interest rates, fees, and loan terms. If you’re not sure how to do this, you can look into credit counseling. A credit counselor will examine your situation and help you decide on the best debt consolidation loan.
Alternatives to a Debt Consolidation Loan
Debt consolidation loans are beneficial but aren't necessarily the best debt relief option for everyone. Luckily, there are other types of debt tools to choose from.
Debt settlement allows borrowers to pay off their debts for less than what they owe. Most debt settlement occurs when a debt settlement company negotiates with creditors on your behalf. The goal is to get the creditors to agree to accept a debt as paid in full for less than what your balance is. This sounds too good to be true, but there are several things to keep in mind.
First, many debt settlement companies will ask you to stop paying all your debts. The objective is to default on your debts to help persuade your creditors to accept a lower settlement amount. Creditors aren’t likely to accept a lower payoff amount if they think you can pay off the entire debt. By stopping payments, you’re trying to convince your creditors that there’s a good chance you can’t pay it off.
Second, not making payments will damage your credit score. You may also have to endure telephone calls and letters from debt collectors while your debt settlement company continues to negotiate with your creditors. Also, if you get one or more debts settled for less than what you owe, the IRS may view the forgiven debt as taxable income.
Debt Management Plan
Debt management plans, or DMPs, are special arrangements between you, a credit counseling agency, and your creditors. Under this agreement, the credit counseling agency negotiates with your creditors to create a payment plan that’s more affordable for you. This typically involves a lower monthly payment, ideally due to lower interest rates.
Under the DMP, you’ll make a single monthly payment to the credit counseling agency or DMP administrator. They’ll then distribute the funds to each of your creditors. For this privilege, you’ll have to pay the credit counseling agency a modest fee each month, along with a set-up fee. In most cases, only unsecured debts are eligible for a DMP. If you enroll in a DMP, you have to be sure you can make your monthly payment. If you don’t, you could get kicked out of the plan and your interest rates may increase.
A Specialized Repayment Plan
If you want to handle your debt repayments yourself, there are two popular debt management strategies to consider. One is the debt snowball method. This works by paying off your debt with the smallest balance as quickly as possible while continuing to make the minimum payment on your other debts. After the smallest debt gets paid off, you use the extra money to pay off your next smallest debt. As you repeat this process, your debt payments will “snowball” into larger and larger amounts until all your debts get paid.
The biggest advantage of the debt snowball method is that paying off a debt gives you a psychological boost. This is important for many people as getting out of debt is as much a psychological challenge as a financial one. The biggest disadvantage of the debt snowball method is that it doesn’t prioritize high-interest debts, which can cost you more in the long term.
To address this, you can do the debt avalanche method. This approach focuses on paying off your debt with the highest interest rate first. During this time, you’ll continue making minimum payments on your other debts, no matter how large or small the balance is. Once the debt with the highest interest rate gets paid off, you pay off the debt with the next highest interest rate and so on.
The main benefit of the debt avalanche approach is that it’s more likely to save you money on interest in the long run. The biggest drawback is that it could take longer to pay off your first debt. This delayed gratification can make the debt repayment process mentally harder.
For most borrowers trying to get rid of their debts, bankruptcy is the option of last resort. You’re not only limited to how often you can use it, but it’ll have a devastating effect on your credit score and can stay on your credit report for 7-10 years.
There are two main types of consumer bankruptcy: Chapter 7 and Chapter 13. If you qualify for Chapter 7 by passing a Means Test, you can discharge the majority of your unsecured debts. Chapter 13 bankruptcy discharges your remaining debts after you pay on a 3-5 year repayment plan. One of the advantages Chapter 13 has over Chapter 7 bankruptcy is that you’re more likely to be able to keep your car or home. This is because Chapter 13 is a “reorganization” type of bankruptcy with its repayment plan.
As you can see, there are a lot of options to consider when getting out of debt. If you want additional guidance on choosing which method might be ideal for your situation, don’t forget to consider credit counseling.
There are many financial tools to help you get out of debt, including debt consolidation. This involves rolling multiple debts into a single account. By doing this, it’s easier to manage your monthly debt payments and avoid being late or missing a payment. But debt consolidation works best when you can also get an interest rate that’s lower than the debts you’re consolidating. This can help save money when paying off your debts. There are several debt consolidation methods to choose from, including a DMP, a personal loan, and a credit card balance transfer.