How Do Debt Consolidation Loans Work? Do You Need One?

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No one really wants to get in debt—it’s just one of those things born out of necessity or sometimes a result of poor financial management. It’s quite normal for most adults to have a debt or two. However, having too many debts with various due dates and interest rates to consider can be quite frustrating and difficult to manage. 

If your debt seems out of control, this article may have a solution for you—a debt consolidation loan. Read on to learn what is a debt consolidation loan, how it works, and whether or not it’s the best workaround for your situation. 

What Are Debt Consolidation Loans And How Do They Work?

Debt consolidation loans are a type of refinancing tool that makes it faster and easier to pay off multiple debts. With debt consolidation, all your outstanding debts and balances are combined into one loan, often with more favorable terms—a lower interest rate or lower monthly payment or both. 

These loans often have a fixed-rate installment, meaning the interest never changes. Thus, you only need to make a single, consistent payment every month. To give you a better idea of how it works, here’s an example:

You have five credit cards with different interest rates and minimum payments. 

  • Card 1: USD$3,500 balance with 15% interest
  • Card 2: USD$7,500 balance with 20% interest 
  • Card 3: USD$9,000 balance with 18% interest
  • Card 4: USD$3,500 balance with 15% interest 
  • Card 5: USD$1,000 balance with 10% interest

If you need to pay down these balances for two years, the total interest cost would be USD$4,450. Now, if you can get a 24-month debt consolidation loan for the total amount of balances at USD$23,000 with 15% interest, you’ll only pay USD$2,166 for interest. That’s almost half of the interest without debt consolidation. 

What’s more, you don’t have to track several payments for different creditors. With debt consolidation, you can make one payment every month, simplifying the whole process and preventing missed payments. 

In general, you can apply for personal debt consolidation loans via credit card companies, online lenders, credit unions, and banks. Banks are more suitable for those with good credit and who already have an existing account with the institution. However, if you’re looking for debt consolidation loans for bad credit, online lenders and credit unions are your better options. 

How Can You Consolidate Your Debt?

Depending on the type and amount of debt you have, there are several options for consolidating debts available to you. The following are two of the most popular methods:

  • Balance Transfer

Credit card providers often provide a balance transfer card. Some even offer promotional periods with 0% interest on such an account, making it appealing. However, you’ll need to have a good or excellent credit score, at least 690 or higher, to qualify. 

  • Personal Debt Consolidation Loan

Personal loans for debt consolidation are offered by most lenders. Personal loans are unsecured, which means that the lender won’t ask for collateral. However, this could mean that your lender may charge a higher interest rate. But then again, if you have a good credit score, your lender may offer a lower rate. 

Other ways to consolidate debts are taking out a 401(k) loan or a home equity loan. However, both options involve risks to your retirement funds or home. So make sure to consider your options before deciding how to consolidate your debts. 

Should You Get A Debt Consolidation Loan?

Debt consolidation loans may be a wise financial move under the right circumstances. In general, here are some signs when debt consolidation loans make sense:

  • You can pay off your debt consolidation loan in less than five years. 
  • You can lower your interest rate by 8% or less. 
  • You have a good credit score that allows you to get lower interest rates.
  • Your debt consolidation payment reduces your overall balance every month.
  • Your monthly debt consolidation payments, including all necessities such as mortgage or rent, don’t exceed 50% of your monthly income.

While debt consolidation may seem like a wonderful solution for managing your finances, it’s not always your best bet. It’s not a silver bullet for all your debt issues. 

Debt consolidation doesn’t address your excessive spending habits which create debt in the first place. Also, it’s not the ideal solution if you’re drowning in debt and have no hope of paying it off even with reduced interest rates or monthly payments. In this case, consider doing DIY debt payoff methods such as debt avalanche or debt snowball and changing your financial habits

On the one hand, if your debt is small and you can pay it off within 6–12 months at your current pace, and you’d only save a negligible amount by consolidating, the hassle isn’t worth it. On the other hand, if the total of your debts is over half your income, you may be better off looking for debt relief programs. 

Takeaway

If you’re dealing with numerous debts and want to reorganize your bills, debt consolidation loans are a sound approach to consider. It can become a lifesaver that helps simplify and streamline your finances. You have to be cautious though. Think carefully if it’s truly the best solution for you. Otherwise, you may end up with more debt, which defeats the purpose of applying for such a loan in the first place.