How Debt Consolidation Loans Work
Debt consolidation loans are installment loans you can use to pay off other debt. Some loan products are marketed specifically as “debt consolidation loans.” However, most often debt consolidation loans are simply personal loans with a fixed rate and fixed term.
There are two types of personal loans that can be used for debt consolidation — unsecured personal loans and secured personal loans.
Unsecured personal loans
An unsecured loan is one that you can get approved for without pledging collateral such as a car or home. A lender reviews your credit history and income to determine whether you qualify. Your signature on the loan agreement is enough to secure funds.
Lenders typically verify your income and employment by requesting pay stubs (or bank statements if you’re self-employed) and other documentation. Many alternative lenders, banks and credit unions offer unsecured personal loans online, so you may be able to take care of the entire application process without stepping into a physical location. Funding can happen within a few days.
Unsecured personal loan products are available for borrowers who have good credit and even those who have less-than-stellar credit. As you can see in the loan comparison table above, borrowers with a score in the low 600s may be able to qualify for an unsecured personal loan to consolidate debt but most likely at a higher interest rate.
Secured personal loans
Secured personal loans are backed by something valuable like a car, home or savings. Pledging collateral to back your loan means the lender has the right to take possession of the asset if you don’t repay it. Collateral reduces risk for the lender.
Some banks offer a lower interest rate for personal loans that use your CD or savings account as collateral.
Here’s how it works: During the period of the loan, the lender will block withdrawals from the account you used to back your loan. The downside is that the lender can seize this account should you fail to repay the loan. But successfully repaying the loan may show your lender you’re a reliable customer and have a positive impact on your credit score.
Online lenders
Secured personal loans are less popular in the online lending space. However, these products may be offered to borrowers who aren’t able to qualify for an unsecured loan and therefore tend to have higher interest rates. If your score isn’t great and you can’t qualify for an unsecured product, handing over the title to your car may be the only way to qualify, but be careful.
There are reputable companies like OneMain Financial offering secured loans, and then there are title lenders. Title loan companies offer the short-term secured loans that you may see advertised on storefronts and commercials.
“At OneMain, you may get a 36% interest rate on a $5,000 loan with your car provided as collateral. Title loan companies’ [interest rates] can be in the hundreds of percentage points,” said Nick Clements, co-founder of MagnifyMoney. Clements warns that you could borrow just $1,000 from a title loan company and owe $1,500 within weeks due to triple-digit APRs.
To make matters worse, if you’re unable to pay back the title loan, you can find yourself without a car and in a never-ending cycle of debt. A debt consolidation loan is supposed to be a tool to get you out of debt. It’s not supposed to cause more financial strain. If using your title is your only way to qualify for a loan, make sure it’s an installment loan where you’re using it as collateral to help you qualify and it’s not a payday-structured loan from a title company because of the high fees.
Advantages of a debt consolidation loan
- Quick online application. You may be able to qualify for a debt consolidation loan within minutes and have your loan funded within days. Many online lenders also offer a prequalification process where you can shop for rates with a soft pull that won’t harm your credit.
- Condenses bills into one easy payment. If you have many payments for credit cards, auto loans, medical bills and more, one payment can be far easier to manage. You can also obtain large loan amounts if you have a substantial sum of debt to consolidate.
- Can reduce your interest rate. It’s fairly easy to do a cost comparison with a debt consolidation loan. If your credit card interest rate is 20% and you qualify for a debt consolidation loan at 12%, you’ll know you’re in for some interest savings.
- Can lower your monthly bill. Taking out a loan with an extended loan term of five to seven years can lower your monthly payment. A lower monthly payment can give you some wiggle room to put money elsewhere. For instance, building up an emergency savings account with the extra cash you gain each month can help you avoid falling back on credit cards or other forms of debt in the future.
- Has a fixed interest rate and installment payments. Having a fixed interest rate and fixed payment schedule means you know how much the loan will cost you in total. There’s also a set payoff schedule that offers some structure if you’re having trouble managing debt. In comparison, credit cards have a variable interest rate, and you can fall into the debt trap of making just minimum payments, which can spiral out of control.
Disadvantages of a debt consolidation loan
- The fees. Many debt consolidation loans have no origination or application fees, but some do. The loan origination fee (if there is one) is often around 1 to 8 percent and deducted from the proceeds of the loan before it appears in your account. Make sure you account for the fees when deciding how much to borrow.
- The allure of an extended payment. The extended loan payoff schedule can be a blessing and a curse. Drawing out the loan term may offer a lower monthly payment, but it could also mean you’ll be paying off the lingering debt for several years. Consider a shorter-term loan to speed up repayment if your goal is to crush debt fast.
- It’s not a lifeline. A debt consolidation loan is probably not going to be the answer to your prayers if you’re experiencing significant financial trouble. You won’t qualify if your credit has already taken a hit because you’re unable to keep up with your current payments. A debt consolidation loan restructures your debt to make it easier to manage. It won’t resolve delinquencies and defaults.
- Good credit may not be required, but credit does matter. You may not be able to qualify for a debt consolidation loan with a competitive interest rate if your credit is less than stellar. Ultimately, you want to land an interest rate that’s better than what you currently have to make the most of a debt consolidation loan.
Things to do before applying for a debt consolidation loan
Consider alternatives
A balance transfer credit card. A balance transfer credit card is probably the cheapest way to consolidate your debt if you use it appropriately. A balance transfer card gives you a 0% APR introductory deal for a certain period of time, often 12 to 21 months. You transfer an existing balance onto the card and pay it off while there’s no interest charged.
There are a few drawbacks to the balance transfer card as well.
- You generally need decent credit to qualify.
- Balance transfer cards may charge a balance transfer fee of 2 to 5 percent.
- Standard interest rates will apply to your balance once the introductory period is over.
- There are also credit limits.
“If you have a lot of debt, you’re going to find it difficult to see more than $5,000 approved on the balance transfer card,” said Clements.
Lastly, getting a balance transfer card may not be the best idea if you’ve maxed out every other credit card in your wallet. You may get tempted to make the minimum payment instead of crushing debt during the interest-free period.
Home equity line of credit (HELOC) or home equity loan. A home equity line of credit (HELOC) and home equity loan are two other examples of secured debt you could use for a debt consolidation. These products are secured by your home and both involve borrowing from your home’s equity. A HELOC is a credit line that you can use and pay back as needed while a home equity loan works like a typical installment loan.
Benefits of both types are generally lower interest rates than personal loans or credit cards (after the 0% introductory period), but you may have to pay closing costs.
Qualification criteria for a HELOC and home equity loan can be stringent.
- You need to pass a credit check.
- Lenders will also review your debt-to-income ratio and loan-to-value (LTV) to determine if you qualify.
- Watch out for the fine print when using a HELOC. Interest rates are variable and the minimum payment may be interest-only at the beginning. The low monthly payment could prolong your debt plan or tempt you to borrow more. Learn more about HELOCs and home equity loans here.
Cash-out refinance. A cash-out refinance is when you refinance your home loan for more than your existing loan amount so you can take cash from the deal.
Say your home is worth $200,000, your mortgage balance is $100,000, and you’re sitting on $20,000 of credit card debt. You refinance the mortgage for $120,000. You take the extra $20,000 in cash to pay off your credit cards. Your credit card debt is consolidated into your 30-year, fixed-rate mortgage. This is an option to consider if you’re looking for a low payment that can be spread out over a long period of time.
“[Cash-out refinances] are one of the most popular ways to use home equity right now,” said Clements. “The HELOC and home equity loan space is still very restrictive ... they’re not particularly easy to get or the cheapest relative to the cash-out refinance.” Learn more about cash-out refinances here.
Set a budget and make a repayment plan
As mentioned above, a debt consolidation loan isn’t a saving grace. Before getting one, you should create a monthly budget. Tracking your money will help you identify and curb overspending habits so you can avoid accumulating even more debt after the consolidation. You should also come up with a game plan. The game plan will help you choose the right product.
Do you want to pay off debt within one or two years? A balance transfer card or short-term loan may be the right choice. A balance transfer card is likely the cheapest short-term solution because it can give you 0% APR for a limited time.
Do you want to spread out your payments over many years? A long-term debt consolidation loan, home equity loan or cash-out refinance may be the best move. The cash-out refinance may offer you the longest repayment term for the lowest price.
Be careful to read fine print to avoid scams
Always look for fees and pay close attention to how much a debt consolidation loan will cost you over the entire loan term. Look at lender reviews before borrowing to make sure the company is reputable. Predatory lenders often take advantage of people who are desperate. Don’t make any rash decisions. If a product seems too good to be true, it’s probably too good to be true. Review terms carefully and ask questions about costs before borrowing.
Which lender is best for me?
The best way to choose the right lender is to research and shop around before making a choice. Read our reviews below to decide which lender provides the best option for your specific needs!
