| Consolidating three credit cards with an average interest rate of 22.99% | ||
|---|---|---|
| Loan Details | Credit Cards (3) | Consolidation Loan |
| Principal | $20,000 | $20,000 |
| Interest % | 22.99% | 11% |
| Payments | $1,048 | $933 |
| Term | 24 months | 24 months |
| Bills Paid/Month | 3 | 1 |
| Total Interest | $4,601 | $2,157 |
Risks of Debt Consolidation
Debt consolidation also has some downsides to consider. For one, when you take out a new loan, your credit score could suffer a minor hit, which could affect whether you qualify for other new loans.
Depending on how you consolidate your loans, you could also risk paying more in total interest. For example, if you take out a new loan with lower monthly payments but a longer repayment term, you may end up paying more in total interest over time.
You can also hire a debt consolidation company to assist you. However, they often charge hefty initial and monthly fees. It's usually easier and cheaper to consolidate debt on your own with a personal loan from a bankor a low-interest credit card.
Types of Debt Consolidation Loans
You can consolidate debt by using different types of loans or credit cards. Which will be best for you will depend on the terms and types of your current loans as well as your current financial situation.
There are two broad types of debt consolidation loans: secured and unsecured loans. Secured loans are backed by an asset like your home, which serves as collateral for the loan.
Unsecured loans, on the other hand, are not backed by assets and can be more difficult to get. They also tend to have higher interest rates and lower qualifying amounts. With either type of loan, interest rates are still typically lowerthan the rates charged on credit cards. And in most cases, the rates arefixed, so they won't rise over the repayment period.
With any type of loan, you'll want to prioritize which of your debts to pay off first. It often makes sense to start with the highest-interest debt and work your way down the list.
Here are a few more details about the most common ways to consolidate your debt.
Personal Loans
A personal loan is an unsecured loan from a bank or credit union that provides a lump sum payment you can use for any purpose. You repay the loan with regular monthly payments for a set period of time and with a set interest rate.
Personal loans generally have lower interest rates than credit cards, so they can be ideal for consolidating credit card debt.
Some lenders offer debt consolidation loans specifically for consolidating debt. They are designed to help people who are struggling with multiple high-interest loans.
Credit Cards
A new card can help you reduce your credit card debt burden if it offers a lower interest rate.
As mentioned earlier, some credit cards offer an introductory period with 0% APR when you transfer your existing balances to them. These promotional periods often last from six to 21 months or so, after which the interest rate can shoot up into double digits. So it's best to pay off your balance, or as much of it as you can, as soon as possible.
Note that these cards may also impose an initial fee, often equal to 3% to 5% of the amount you are transferring.
Home Equity Loans
If you are a homeowner who has built up equity over the years, a home equity loan or home equity line of credit (HELOC) can be a useful way to consolidate debt. These secured loans use your equity as collateral and typically offer interest rates slightly above average mortgage rates, which are generally well below credit card interest rates.
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Student Loans
The federal government offers several consolidation options for people with student loans, including direct consolidation loans through the Federal Direct Loan Program. The new interest rate is the weighted average of the previous loans. Consolidating your federal student loans can result in lower monthly payments by stretching out the repayment period to as long as 30 years. However, that can also mean paying more in total interest over the long term.
Private loans don't qualify for this program, although you may be able to consolidate them with another private loan.
Debt Consolidation and Your Credit Score
A debt consolidation loan may help your credit score in the long term. By reducing your monthly payments, you should be able to pay the loan off sooner and reduce your credit utilization ratio (the amount of money you owe at any given time compared to the total amount of debt you have access to). This, in turn, can help boost your credit score, making you more likely to get approved by creditors and for better rates.
However, rolling over existing loans into a brand new one may hurt your credit score. Credit scores favor older debts with longer, more consistent payment histories.
Qualifying for Debt Consolidation
Borrowers must meet the lender's income and creditworthiness standards to qualify for a new loan. For example, for a debt consolidation loan, you may need to provide a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.
Does Debt Consolidation Hurt Your Credit Score?
Debt consolidation could temporarily affect your credit score negatively because of a credit inquiry, but it can help your credit score in the long term if you use it correctly. Most people who make their new payments on time find their credit score increases significantly as they avoid missing payments and decrease their credit utilization ratio.
What Are the Risks of Debt Consolidation?
Consolidating debt could potentially lead to you paying more in the long run, particularly if you consolidate credit card debt but then continue to use the cards you paid off. There may also be a minor, short-term ding to your credit score.
What Is the Best Way to Consolidate Debt?
The best way to consolidate your debt will depend on the amount you need to pay off, your ability to repay it, and whether you qualify for a relatively inexpensive loan or credit card. Fortunately, you have a number of options.
What Is Debt Settlement?
Not to be confused with debt consolidation, debt settlement aims to reduce a consumer's financial obligations rather than the number of creditors they have. Consumers can work with debt-relief organizations or credit counseling services to settle their debts. These organizations do not make actual loans but try to renegotiate the borrower's current debts withcreditors.
The Bottom Line
Debt consolidation can be a useful strategy for paying down debt more quickly and reducing your overall interest costs. You can consolidate debt in many different ways, such as through a personal loan, a new credit card, or a home equity loan.
