How debt consolidation loans work
Plenty of people have trouble keeping up with their debt, but dealing with multiple creditors and varying interest rates makes it much harder to keep in check. Unexpected costs like medical bills or auto repairs can leave you racing to meet minimum payments and unable to budget your bills.
If you’re juggling debts and constantly working to get ahead of your payments, you might benefit from a debt consolidation loan.
What is debt consolidation?
Whether it’s student loans, hospital bills or credit card debt, paying off multiple bills with varying interest rates can quickly become frustrating.
Chaotic payment plans like these can make it impossible to set a workable budget and predict your monthly expenses. Lots of debt can also weigh down your credit score, making it much harder to get an auto loan or begin the mortgage process. Rather than constantly paying different amounts to a number of creditors, you can help clear the cobwebs by applying for a debt consolidation loan.*
If you’re struggling with debt, consolidation provides some hope by providing you with an exact end date. As long as regular payments are made and your other spending stays in check, your debts could be cleared in a matter of three years.
On the other hand, continuing to make minimum credit card installments on multiple lines of credit could take years before they are paid off, all while accruing additional interest that puts you even farther behind the curve.
Debt consolidation loans are typically structured with a fixed rate, meaning the amount you pay in interest each month won’t change. If you’ve been paying off multiple credit cards with varying interest rates, consolidating them into one fixed rate loan presents an obvious advantage. With all of your debts folded into a single fixed rate loan, your monthly payments remain steady and easily predictable.
If debt consolidation seems like a better alternative to juggling multiple small payments, there are a few considerations to make before you apply for a loan.
How does a debt consolidation loan work?
Debt consolidation works by taking out a personal loan, which pays off your existing debtors with one installment. Your debt then transfers to the lender who issued the loan, who works with you to build a suitable repayment plan.
By taking out a personal loan to consolidate your debts, the lender provides a lump sum that settles the debt with your creditors. Since all of your creditors have now been paid back in full, you’ll only have to focus on a single payment structure with your lender.
When to consolidate your debt
Debt consolidation seems like an excellent solution for anyone struggling with their bills, but not everyone qualifies for the option. Here are few tips to help organize:
- You’ve made a plan
- You have lots of debt, but it’s not out of control
- You’re managing your spending
- You have a high enough credit score
You’ve made a plan
Some borrowers have rushed into a debt consolidation agreement before getting their personal finances stable enough to handle the monthly payments. Many borrowers who apply for a consolidation loan are doing so because they ran into financial trouble in the past. These negative spending habits can be hard to break, and usually don't stop just because debts are consolidated.
Before you apply, it’s important to develop a thorough and honest budgeting plan that you can stick to throughout the life of the loan. Negative spending habits can be hard to break, and without a plan in place to overcome them, you could find yourself even deeper in debt than before you decided to consolidate.
You have lots of debt, but it’s not out of control
If you have a moderate amount of consumer debt that’s hard to get ahead of, applying for a personal loan to consolidate those payments is probably a good solution. Generally, lenders structure these loans with a five-year amortization schedule, so you’ll have to be confident you can pay off the full sum in that timespan.
With too much debt on your plate, you might not be able to pay off the full amount in the limited time you have. In addition, your lender will review your finances to gauge whether they’ll approve the loan.
Generally, your total debt amount, excluding mortgages, cannot exceed 40% of your gross income. With more than 40% of your income going toward debt payments, you may have a tougher time consolidating those payments.
You’re managing your spending
Many of us have had bad spending habits and bought things we shouldn’t have in the past. However, if those tendencies are driving you deeper into debt, you might want to curb that behavior before taking on debt consolidation.
Consolidating all of your debt under one personal loan won’t make that debt go away. Some borrowers have made the mistake of continued mismanaged spending after consolidation. Without setting a solid budget in place and sticking to it, you can quickly fall behind on your monthly payments.
If your budget is under control and frivolous spending is in the past, you’ll be ready to take on a debt consolidation plan.
You have a high enough credit score
Credit card debt can do some damage to your credit score, but if you’ve made timely payments that meet the minimum on those bills, your credit score might be high enough for a low interest rate.
Borrowers with high balances but decent credit scores are the best candidates for debt consolidation financing because lenders can be confident about your ability to repay. Most of the time, a credit score in the mid 600s is considered fair and can get you approved for a loan with a reasonable rate.
Any lower than that, and it might be a good idea to continue making multiple minimum payments until your credit improves enough to get a good deal on a loan.
Do debt consolidation loans hurt your credit?
Consolidating your debts allows for predictable budgeting and lower monthly expenses, but it does mean your credit score will take a hit. Creditors use your credit score to get a picture of your debt management history and any delinquent payment patterns or missed payments in the past.
A higher credit score means lenders will be willing to offer more borrowing opportunities with favorable terms, while a lower score means those options may be more limited. A debt consolidation loan, if paid off on time, can certainly improve your credit in the long term, but in the short term, you can expect your score to drop a few points.
Whichever debt consolidation plan you chose, approval will require a hard inquiry on your credit. A hard inquiry happens when a lender requests to check your credit report in order to determine your eligibility for a loan, and can drop your score by up to five points. For this reason, it’s a good idea to limit hard inquiries on your credit report since multiple requests can bring down your score a considerable amount.
Before you apply for a debt consolidation loan, be sure that you are likely to be approved so you don't lower you score unnecessarily.
If your creditors are making it impossible to budget your expenses, consolidating that debt could bring you some piece of mind. With a solid spending plan in place, you’ll be ready to wipe away those varying interest rates and pay off the loan with a steady, unchanging payment.
With that debt cleared up, you’ll be able to expand your financial opportunities and make further investments, like buying a house.
*This product is not offered or brokered by Guaranteed Rate Companies.