Ultimate Guide to Debt Consolidation Loans

Everything you need to know about finding the right debt consolidation loan.

Debt consolidation loan types

Debt consolidation loans make it possible for borrowers to combine multiple debts into a single new one with fixed monthly payments. Ideally, debt consolidation loans also lower your average interest rate and reduce the repayment period. Check out the rates and terms of leading lenders and see which debt consolidation option is best for your circumstances.

How do debt consolidation loans work?

You’re having trouble managing your debts. There are too many to keep them all straight. You have a mortgage note, a car payment, five credit cards with one maxed out. Not to mention the student loan that you’re still paying.

If this sounds like your current situation, you may be the perfect candidate for a debt consolidation loan.

With a debt consolidation loan, a lender offers a single loan to pay off other debts, such as credit card debt, medical debt, and back taxes. If you qualify, you pay fixed monthly installments for a set period, usually between two and five years. Debt consolidations loans can be a smart choice for consumers with a steady income, a decent credit score (640 or higher) but an overwhelming number of creditors. As well as saving you money on interest, debt consolidation loans can also improve your credit score and lower your monthly payments.

However, they are not for everyone. Debt consolidation loans can also increase the overall cost of your debt. And if you convert them to a home equity loan, you could lose your home.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of debt consolidation loans.

Pros
  • Can help you save on interest.
  • Lower monthly payments.
  • Can improve your credit score.
Cons
  • Could increase overall interest cost.
  • Your property may be at risk if you use it as collateral.
  • May tempt you to spend more instead of paying off debt.

Debt consolidation loan types

The idea behind debt consolidation loans is to consolidate all your high-interest debts into one with lower interest rates and better terms. However, there are more than one type of debt consolidation loan.

Personal loans

Unsecured personal loans are the most common type of debt consolidation. They are also the most popular reason for applying for a loan.

Two things to keep in mind when comparing personal loans are your credit score and fees.

Low-interest unsecured personal loans are only available to borrowers with excellent credit. If your credit needs some work you may not qualify for a loan with lower rates than your current debt. Don’t forget about origination and penalty fees either.

Some lenders advertise competitive rates but gloss over hefty origination fees of up to 6%. These fees are typically deducted from the loan amount so keep this in mind when determining how much you want to borrow.

 

WEIGH THE PROS AND CONS

Compare the pros and cons to make a better decision.

Pros
  • Lower interest rate with good credit.
  • Lower payment.
  • The convenience of paying one lender each month.
  • No collateral required.
  • Easy application process and fast approval.
  • If approved, funds will be transferred to your account within a few days.
Cons
  • Loan origination and administration fees may apply.
  • Must have good credit to qualify for a good interest rate.
  • Longer loan terms could cost you more in interest.

Balance transfer credit cards

If you have credit card debt, reducing or eliminating the interest you pay on that debt is a good first step towards becoming debt-free. If you pay high interest rates on your credit card debt, consider transferring that debt to a balance transfer credit card. Some balance transfer cards offer a 0% interest rate for 12-21 months, providing a window of opportunity to pay down debt interest-free, which can save you hundreds or even thousands of dollars.

Balance transfers aren’t free, however. The typical balance transfer card charges a fee that ranges from 3-5% of your balance transfer. And interest rates are typically high after the 12-21 month “introductory period” expires.

WEIGH THE PROS AND CONS

Compare the pros and cons to make a better decision.

Pros
  • You can transfer your balance to a credit card with better terms and close your old account.
  • You can qualify for a promotional interest rate if you have excellent credit—it can be as low as 0% APR for six months or more.
  • No collateral required.
  • Easy application process and rapid approval.
Cons
  • Hard to qualify for if you have less-than-perfect credit.
  • High balance transfer fees (for each balance transferred).
  • Higher interest rate if you don’t qualify for a promotional interest rate.
  • Credit could be hurt with a balance transfer (but can be recovered with consistent on-time payments).
  • Risk of incurring more debt if not disciplined with your spending.

Home equity loans and lines of credit

Home equity lines of credit (HELOC) and home equity loans are two of the most effective ways of lowering your interest costs. Not only are their rates lower than those of credit cards and personal loans, the interest you do pay is tax deductible. You don’t even need great credit to qualify for great rates. But there are serious risks to consider.

The downside of this option is that if you fail to repay the loan, you could lose your home. You could also wind up owing more than your house is worth if you dip into your equity and the value of the property drops. Another concern is that home equity loans and lines of credit are secured loans, which are much harder to discharge in a bankruptcy.

WEIGH THE PROS AND CONS

Compare the pros and cons to make a better decision.

Pros
  • Low-cost consolidation loan.
  • Low interest rates.
  • You don’t need great credit to qualify.
  • The interest you pay is tax deductible.
Cons
  • Secured loan using your home as collateral.
  • Variable interest rate. Could result in higher monthly payments over time.
  • Hidden fees. Potentially expensive origination, maintenance, and closing fees.
  • If housing prices drop, the lender can reduce or freeze your credit limit.
  • You could wind up with an underwater mortgage.

Home equity loan vs. HELOC

If you decide tapping into your home equity is the best way to consolidate your debt, you still have one more choice to make. Should you get a home equity loan or a line of credit?

Home equity loans

Home equity loans are a secondary mortgage that uses the equity in your home as collateral. You get a lump sum, fixed monthly payments, and a set repayment schedule.

Home equity lines of credit

HELOCs work as a secured credit card. Your line of credit depends on how much equity you have. Instead of a lump sum you can draw money whenever you need it. You only pay interest on the money you withdraw and some don’t even charge origination and closing fees.

Still unsure? Let’s put their pros and cons side by side.

WEIGH THE RISKS AND BENEFITS

Compare the features of home equity loans and HELOCc before you make a decision.

Home equity loans
  • Low rates.
  • Fixed payments make it easier to budget.
  • Fixed payoff date.
  • Lump sum.
  • More expensive closing costs.
Home equity lines of credit (HELOC)
  • Low and variable rates.
  • Zero or low closing costs.
  • Interest payments could go up any time.
  • Without fixed payments budgeting is a challenge.

Cash-out mortgage refinancing

If you own a home and you have built equity in it, a cash-out mortgage refinance may be the best way to consolidate your debts. A cash-out refinance allows you to renegotiate your mortgage terms and get a lump sum of cash in the process. Typically, mortgage rates are lower than those for credit cards, personal loans or even home equity lines of credit. This allows you to pay off high interest debt with mortgage rates, which are also tax-deductible. There is a catch though.

As with home equity loans, you are putting your home at risk if you default on your mortgage. Mortgage refinancing isn’t free. Over the long run, you can save a lot of money when you consolidate your debt with a cash-out mortgage refinance. But there are initial costs to consider.

A cash-out refinance replaces your existing mortgage with a larger one. The difference between the new loan and the existing one is taken out as a lump sum.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of a cash-out refinance

Pros
  • Liquidate your equity in a lump sum.
  • Access equity without a second mortgage.
  • One loan, one payment.
  • Lower interest rate than you’d get on a second mortgage.
  • Interest is tax deductible up to $750,000.
  • Fixed interest rates.
Cons
  • Liquidate your equity in a lump sum.
  • Access equity without a second mortgage.
  • One loan, one payment.
  • Lower interest rate than you’d get on a second mortgage.
  • Interest is tax deductible up to $750,000.
  • Fixed interest rates.

Be savvy about debt consolidation loans

Before you decide whether a debt consolidation loan is right for you, be sure to do your homework. You should:

Shop around

Check with a variety of financial institutions and loan consolidation organizations to determine which offer the lowest interest rates and fees, easiest monthly payments, and best overall service. SuperMoney’s comparison tools for personal loans, HELOCs, home equity loans, balance transfer cards, and mortgage refinancing make this easy.

Calculate the cost

Getting a loan isn’t just about signing on the dotted line and walking away with a check. There may be additional fees or costs. Make sure you know what they are and that you can afford the loan.

Compare your options

Consider how much you pay now versus how much you will pay with the new loan. If your payment on the debt consolidation loan isn’t less, it’s the wrong loan.

Check your credit report

It will help you understand your credit problems and determine whether a debt consolidation loan is a good option. Make sure the information in your credit report is accurate.

Add it all up

Before you decide, review your bills to determine how much you really owe. Determine how much of a loan you need. Be sure not to include bills with lower interest rates than the loan.

Plan a budget

The only way to get out of debt is to make a commitment and have a plan. Compare your income and your expenditures to determine how this new loan will affect you and where you can cut back.

When is debt consolidation a good idea?

Debt consolidation loans can be a good option for borrowers overwhelmed by the number of creditors but have enough income to pay off their debt.

However, if your debt exceeds your income, a debt consolidation may not be enough. You also need to consider your FICO credit score. Borrowers with fair or bad credit may not qualify for a debt consolidation loan that lowers their interest rate. In such cases, you may have to resort to other debt relief options, such as a debt settlement or even bankruptcy.

As with anything, never go into this process blindly. Do your research to make sure it is the best move for your situation.