What is a debt consolidation loan?
A debt consolidation loan is an unsecured personal loan that you take out specifically for the purpose of consolidating debt. You take out a low-interest rate installment loan, typically with a term of 24-48 months. Then you use the funds to pay off your credit card balances and other debts. This leaves only the loan to pay back, so you consolidate multiple bills into one simplified monthly payment.
How do debt consolidation loans work?
The reason a debt consolidation loan works is because it lowers the interest rate applied to your debt. With lower accrued monthly interest charges, you can focus your debt payments on repaying the principal (the actual debt you owe). This speeds up how quickly you can get out of debt. In many cases, you can get out of debt in a few years, even though you may pay less each month. You save money overall and reduce your total monthly debt payments. It’s a win-win in the right situation.
Step 1: Determine how much debt you wish to consolidate
If you’re thinking of using a debt consolidation loan, the first thing you need to do is determine how big of a loan you’ll need to pay off all your debts. These loans don’t just work for credit card debt, although that’s one of the most common types of debt you consolidate.
Here’s a list of everything you can potentially consolidate:
- General-purpose credit cards
- Gas cards
- Store credit cards
- In-store credit lines
- Other personal loans
- IRS or state tax debt
- Child support arrears
- Medical bills
- Student loans*
*Not all lenders will allow you to consolidate student loans with other unsecured debts. However, some lenders have begun to allow you to combine them.
You cannot use a debt consolidation loan to consolidate secured debts, such as:
- Mortgages
- Home equity loans
- Home equity lines of credit (HELOCs)
- Auto loans
Step 2: Shop around for the best credit consolidation loan
Different lenders have different lending standards, such as the maximum amount they’re willing to lend and the maximum term (length of the loan). They’ll also have different credit score requirements for getting approved.
You want to shop around and at least get quotes from several different lenders.
- Online loan comparison tools can be useful to compare loans from multiple lenders at once.
- You should also check with local banks and credit unions, especially since credit unions often offer lower interest rates.
- Also check those offers you may be receiving in the mail. These are “pre-approved,” which means the lender ran a soft credit check and identified you as a good candidate for their loan. You will be more likely to get approved.
Consolidation Tip: Make sure as you shop around that you only ask for quotes! Each time you apply for a loan, you authorize the lender to run a credit check. These checks reduce your credit score by a few points, so authorizing multiple checks can dent your credit score. Only apply for a loan once you decide it’s the best fit.
How to find the best personal loan for debt consolidation
The best credit card debt consolidation loan will provide:
- A debt amount that covers everything you want to consolidate
- Low APR
- A term with a monthly payment you can afford
- Low or no fees, such as loan origination fees
- No penalties or fees for early repayment or extra payments
Step 3: Apply for the loan
When you apply for a debt consolidation loan, the lender will look at two main factors to decide if they want to extend the loan to you:
- Your credit score and credit history
- How much existing debt you currently have
Lenders will usually ask what the purpose of the loan is. When you tell them it’s for consolidation, they’ll want to know which debts you want to consolidate. They’ll ask for accounts and current balances. Then they’ll evaluate whether they want to approve you.
Creditworthiness
Lenders typically have a minimum credit score requirement. Your credit score must be above this number or you won’t get approved. They’ll also review your credit report to see how consistent you’ve been at keeping up with the payments on your other debts. Basically, creditworthiness evaluates how likely you are to default or to pay your loan back.
Debt-to-income ratio
Lenders also want to see how much existing debt you hold to make sure you can afford the loan. To evaluate this, they check your debt-to-income ratio (DTI). This measures how much debt you have relative to your income. You divide your total monthly debt payments by your total income. Then they factor the new loan payments in to make sure you’d be able to afford the loan.
Most lenders won’t give you a loan if the monthly payment on the new loan puts your DTI over 41 percent. Some lenders are willing to be flexible and go as high as 45 percent. But if debt payments currently take up more than 50 percent of your income, you’re unlikely to get approved.
On a consolidation loan, the loan underwriter will factor out the debt payments that the loan will pay off. In other words, as long as your DTI is less than 41 percent with the new loan payments factored in and your credit card payments factored out, you will get approved.
Step 4: Paying off your balances once you’re approved
Once the lender approves you for the loan, two things could happen:
- The lender will deposit the funds into your bank account.
- They’ll send the funds directly to your creditors to pay your balances off.
If your DTI is right on the line, many lenders will require something called direct disbursement. This means they will want to send the funds directly to the credit card companies to pay off your balances. This helps them ensure that you actually use the funds to pay off all the debts you said would pay off.
If they don’t require direct disbursement, then the funds will be deposited directly into your account. This can take up to a few business days. Once you have the funds, you’ll want to pay off all of your balances quickly, so you don’t use the money from the loan on other things.
Step 5: Paying off the loan
Once all your other debts are paid off, this should hopefully leave the loan as the only unsecured debt you have to repay. In addition to their low fixed interest rates, installment loans offer the benefit of fixed monthly payments. You will pay the same amount each month on the due date. This can be easier to manage than credit card payments, which can increase depending on how much you charge.
These tips can help ensure you use a debt consolidation loan effectively:
Set a budget
You need to set a budget or revisit your existing budget once you have the loan. You’ll want to make sure your budget is balanced, so you can afford the loan payments and your other obligations. It’s also a good idea to make sure you build in emergency savings in your budget. This will help ensure you don’t start using credit cards to cover unexpected expenses and emergencies.
Don’t make new charges
You want to avoid using credit cards again until you have the loan paid off. With your balances paid off, it may be tempting to start charging again. But if you don’t repay the loan first, you can end up with more debt following consolidation, rather than less.
Make extra payments whenever possible
If you receive money from a tax refund or another source, use it to pay off the loan faster. This is why you want to avoid loans with early repayment penalties because you want to eliminate your debt as quickly as possible.
Is a debt consolidation loan a good idea in your situation?
When debt consolidation loans work, they can provide immense relief from credit cards and other debts. You can save time to become debt-free faster, save money each month and save thousands in interest charges overall.
Still, just because you can get approved for a debt consolidation loan, that doesn’t automatically make it the best choice. There are unscrupulous lenders out there that will approve people for high loan amounts even with bad credit. Then you can end up trapped in a loan you can’t really afford.
To avoid this, you need to carefully evaluate your own financial situation before you even start shopping around for loans and talking to lenders. This simple two-question test can help you decide if a consolidation loan is the best option for you.
