Is a Debt Consolidation Loan Right for You?

How to know when it makes sense to use a debt consolidation loan to get out of debt faster.

If you’re juggling multiple high interest rate credit card balances, you may be getting offers for debt consolidation loans. In the right circumstances, these loans can make it faster and easier to pay off your debt and may even lower your monthly payments. But these loans aren’t right for everyone, and in the wrong circumstances they could end up making your financial situation worse. So, how do you know when it’s the right time to consolidate with a debt consolidation loan?

This guide will teach you everything you need to know about personal consolidation loans. We also offer a simple test that can help you evaluate if you’re a good candidate for a loan. Finally, you’ll find questions you need to ask yourself and your lender before you decide to take out the loan. If you still have questions, call us at 1-888-294-3130 for a free evaluation with a certified credit counselor. They can help you evaluate which debt relief option is the best fit for your unique financial situation.

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.

Use a debt consolidation loan to consolidate credit card debt

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 right 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.

What to look for in a consolidation loan

  • A debt amount that covers everything you want to consolidate
  • Low APR
  • A term that will provide monthly payments 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:

  1. Your credit score and credit history
  2. 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. You 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:

  1. The lender will deposit the funds into your bank account.
  2. 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. These types of installment loans offer another benefit over credit cards besides low APR, which is fixed 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 ever 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.

How much unsecured debt do you owe, not including student loans?
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What is your credit score?
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8 questions to ask before you sign a debt consolidation loan agreement

Questions to ask your lender

What will the total cost of this loan be?

You will want to know the total cost of the loan (principal + total interest charges + fees), so you can compare the cost savings with other solutions. You should receive a Truth in Lending disclosure, which should clearly detail:

  • Total costs
  • Total interest charges
  • Monthly payments
  • Number of payments

If the total cost is not significantly lower than what you could accomplish with higher monthly payments, or with another solution such as a debt management program, you may want to keep looking.

For a debt consolidation loan to be truly beneficial, you want an interest rate that’s around 10 to 11 percent. Rates on personal loans range from 5-36 percent, depending on the lender and your credit score.[1] Rates are current higher because the economy is strong. Even with an excellent credit score, the average APR on personal loans is 10.3%-12.5%.

Is there any way to reduce the APR on the loan?

Some lenders will reduce the APR on the loan if you agree to certain terms. A common way to shave down APR is to agree to sign up for AutoPay. This means your loan payments will be deducted from your bank account automatically. As long as you make sure you’ll be able to meet the payment obligation each month on the due date, this can be an easy way to reduce your rate.

How and when will you disburse the funds?

It’s important to know what will happen once you get the loan, before you actually get the loan. Lenders have different times that it takes before they disburse the funds. Some may disburse within a few days, while others can take up to a week.

This matters because you may need to make certain bill payments in the interim. If your bill is due on the 5th and the lender will disburse the funds on the 8th, then you’ll need to make a payment to avoid late fees.

You also want to know if they plan on disbursing the funds to your account or if they’ll send the funds directly to your creditors.

Can I pay off this loan early without penalties or fees?

Always make sure that you can pay off the loan early without incurring fees or penalties. Paying off a loan quickly is always in your best interest. You don’t want to incur extra costs because you’re trying to be responsible by paying off your loan quickly.

Questions to ask yourself

Can you afford higher loan payments, so you can shorten the term?

Choosing the longest loan term that the lender allows will give you the lowest monthly payments possible. But it will also mean that you stay in debt longer and pay higher interest charges overall. You want to pay off a consolidation loan as quickly as possible. This will make it easier to avoid ending up with more debt because you start charging on your credit cards again before you pay the loan off.

Always check your finances to see how much you can reasonably afford to pay without creating undue stress on your budget. If you can afford a 36-month consolidation, that will be more beneficial that a 48-month loan. The higher monthly payments will usually be worse getting out of debt faster, as long as you can afford it.

Will you be able to stop charging once your credit cards are paid off?

One of the big dangers with using a personal loan to consolidate is that it will usually leave your credit card accounts open. In rare cases, a lender might require you to close your credit cards in order to get approved, but in most cases, they allow you to keep your accounts open and active.

This is good for ensuring you don’t damage your credit score by closing those accounts. However, you’ll have zero balances on all your cards. It can be extremely difficult to avoid making new charges until you pay off the consolidation loan.

Think ahead. Will you be able to cover vacations and holidays and even day-to-day expenses without relying on credit? If the answer is no, then you’re at high risk of ending up with more debt after you consolidate, instead of less.

How much does this really reduce your interest rates?

You want to make sure that the loan is providing significant cost savings versus traditional payments and other solutions. A consolidation loan only does this when you have a low interest rate. It also depends on the rates being applied to the existing debts you plan to consolidate.

So, while you can use a consolidation loan to pay off medical bills, the question is, should you? It may help you avoid medical collections, but medical bills don’t have interest charges. Consolidating them means you will increase your total costs. You may be better off setting up a separate repayment plan with the medical service provider.

The same is true on consolidating other personal loans. In most cases, you don’t want to use a debt consolidation loan to pay off an existing loan if the APR is higher. Even though you may reduce your total monthly payments, this will increase your total costs.

On the other hand, if you have a bunch of credit cards that have rates over 20% APR and you get a loan at 10% APR, it’s going to provide significant savings.

Is there a different solution that would provide more benefits that you need?

Loans aren’t the only way you can consolidate. There may be other solutions that are a better option, depending on your situation.

  • Balance transfer credit cards can help you consolidate credit card balances, interest-free in some cases. If you have a high credit score, you may qualify for 0% APR for up to 18 months on balance transfers, this would give you up to 18 months to pay off the consolidated debt without worrying about any interest charges. This works best when you owe less than $5,000
  • Debt management programs also consolidate credit cards and other unsecured debts into one monthly payment. However, you don’t take out new financing and still owe your original creditors. It’s essentially a professionally assisted repayment plan. This solution will work even if you have bad credit or owe over $100,000. It also freezes your credit card accounts, so you can keep charging.