With credit card debt at $16,048 for the average indebted household, there’s plenty of reasons for credit card users with revolving credit card balances or high interest rates on that debt to consolidate it.
A personal loan for debt consolidation is one option to dealing with debt. It can help you save money over the long term if the interest rate and fees on the new loan are lower. It can also offer a single structured installment loan payment that pays down the principle over a specific term, leaving you with one bill instead of many.
In this article
What is debt consolidation?
A debt consolidation loan is another term for a personal loan you get from a bank, credit union or other lender. Instead of making many payments to different creditors, you make one loan payment.
Using this personal loan for debt consolidation allows you to pay off balances on high-interest credit cards, for example. Instead, you’ll pay a fixed, monthly amount to the lender for a specific amount of time, usually two to five years.
The interest rate on the debt consolidation loan depends on your credit score. Your interest rate is unlikely to change for the life of the loan.
Difference between debt consolidation and debt settlement
If you’re considering getting a debt consolidation loan, don’t confuse it with a debt settlement.
Some companies advertise that they can help consumers consolidate credit card debt through debt settlement. A debt settlement company will contact your creditors on your behalf to negotiate lower payments to settle the debt.
One of the risks of this, however, is that a debt settlement company may try to convince you to stop paying creditors and to instead pay into a separate account that it controls. It uses that money to try to negotiate with your creditors to reduce the amount of principal you pay off.
If you stop paying creditors, it can hurt your credit score. It could also eventually lead to debt collectors contacting you for payment. And even if your creditor agrees to accepting less than the full amount you owe, interest and penalty fees will be added.
The Consumer Financial Protection Bureau says that some companies are legitimate, but the services can be risky. The CFPB recommends first talking with a non-profit credit card counselor.
Debt consolidation is different. It doesn’t settle your debt for a lesser amount but provides a personal loan so that you can get a lower interest rate than what your credit cards currently offer.
When is the right time to merge debt?
By simplifying your debts to different creditors into one payment, you may find a personal loan for debt consolidation that has a lower interest rate than what you’re currently paying.
Consolidating debt can also help improve your credit score. By paying off high-balance credit cards, you can lower the credit utilization ratio on the cards.
Using up to around 35% of the credit limit on a credit card is a good percentage that can impact your credit score. Using a higher percentage can mean you’re maxing out your credit cards, which can hurt your credit score. The amount owed on accounts determines 30% of a FICO score, one of the major credit score companies.
If you have multiple credit cards with a high utilization ratio in each, you may not be able to get a personal loan to consolidate your debt because you likely won’t be approved for enough credit to consolidate.
Advantages and disadvantages of personal loans
Before getting a debt consolidation loan, here are some things to consider:
- Interest rate
Check the interest rates on the loans you’re consolidating to make sure the new rate is lower.
- Teaser rates
A debt consolidation loan may have a low interest because it’s a “teaser rate” that only lasts for six months or so. Find out how much it can increase.
Extra costs may hidden in the loan. Ask the lender what the total cost is and how it is identified. “Origination fees” can be 1-6% of the loan.
- Add it up
Add up your current debt payments and include the fees and interest you pay now. Compare them to the monthly payment for the debt consolidation loan.
Personal loans can simplify your financial life with one payment. By checking these factors, you can determine if a debt consolidation loan is worthwhile.
Balance transfer credit cards
Another option for multiple credit card debts is to transfer the balances to one credit card account. It sounds counter-intuitive, but it can work.
A 0% or low-interest balance transfer is often offered if you apply for a new credit card. One of your current credit card issuers may allow debt from other credit cards to be consolidated on its card at no interest within a promotional period of up to a year.
The disadvantage of the transfer is if you don’t pay the balance off before the teaser rate expires. That can take a lot of discipline. If you don’t think you can do that, then a personal loan may be a better idea.
Many low credit card transfer offers have a “balance transfer fee” this is usually a certain percentage of the amount transferred, the CFPB warns.
Also, if you use the same credit card to buy things after using the balance transfer offer, you’ll be charged extra interest on those purchases. You may want to use a different card for other purchases.
There are other ways to merge debt. Here are some options:
- Debt repayment plan
Call your creditors to see if they’ll allow you to set a payment schedule that works within your budget. A small payment each month is better than nothing to creditors. Be sure you can afford the payment and don’t miss a payment, which can cause the debt collector or creditor to abandon the agreement.
- Settle for less than you owe
This differs from what debt settlement companies offer you. You can try to settle for less than you owe with a debt collector. Be aware that one collector may accept a partial payment as a settlement and then sell the balance to another collector.
- Home equity loan
This is risky because if you default on this loan, you could lose your house in foreclosure. A home equity loan will likely have a low interest rate, though the loan will decrease the net worth of your home until the loan is repaid.
How to choose the right lender?
When looking for a debt consolidation loan, shop for a lender that has low fees, a low interest rate and other terms that can benefit you, such as payments for five years if you want them for that long.
Also look at how much its late fees are and if it allows you to change the payment amount if you’re low on funds for awhile.
Ask if you can get a lower interest rate by getting a co-signer for the personal loan.
The right strategy for debt consolidation
Your best strategy for using a debt consolidation loan is to pay it back as quickly as possible. If the fees and interest rate make the total monthly payment less than what you’re paying on multiple credit cards and other unpaid accounts, then a debt consolidation loan can be a good option.
But it only works well if you use it to pay off your debt faster. If you don’t, you could be extending your debt and end up paying more over time.
Also remember what got you into this mess in the first place. If you don’t deal with the credit problems that led to your debt, then combining them into one loan won’t fix anything.
To compare personal loans that can be used to consolidate debt, check out the personal loan reviews at SuperMoney.