Use this process to benefit from debt consolidation loans and ditch your debt for good
I get at least two or three offers for credit cards every week. It’s so easy to build up a mountain of debt from multiple creditors and its even easier to let it get away from you.
Getting back on track isn’t as easy but debt consolidation loans have come through as one of the best tools to save on interest and consolidate into one payment.
I've used debt consolidation to rebuild my credit score and dig myself out of debt. It's a simple process and can work for anyone.
In fact, I used a debt consolidation loan to add 140 points to my credit score after ruining my credit.
So how can you actually use this?
A survey on debt found that up to 20% of late payments are because someone just forgot to send in the payment. That one missed payment can lower your credit score by more than 100 points, resulting in higher interest rates besides the late payment fee.
Worse still is that most credit card rates reset to a higher rate if you miss a payment.
Besides having to manage all those separate credit card bills and other debts to make sure you pay on-time, it’s impossible to keep track of all the interest rates.
So you don't even need to have bad credit to use debt consolidation. In fact, the best time to use it is before a missed payment ruins your financial life.
I’ve used debt consolidation loans once to pay off a bunch of individual credit cards and store credit after we finished remodeling our house. I know others that have used debt consolidation just to get their loans in order and put their finances back on track.
Debt consolidation is a powerful tool but it’s too often misunderstood by the debt naysayers that think you need to totally avoid all debt. That’s not an answer, it’s a slogan.
What are Debt Consolidation Loans?
Debt consolidation loans are fairly simple, it’s just one loan you take out to pay off your other debts. You are consolidating your debt into just one loan instead of many. You’re able to make one payment each month which saves you from missed payments and it’s all much easier to manage.
Debt consolidation loans can help you improve your credit score as well. That’s because of the way the credit bureaus calculate your score and how different loans affect it.
- Credit card debt is listed on your credit report as revolving debt because you can continue to charge on it. You don’t have fixed payments or a fixed payoff date.
- Most other loans are listed as non-revolving debt because they have fixed payments and a payoff date.
Up to 10% of your credit score depends on the types of credit, whether revolving or non-revolving, on your report. The rating agencies see revolving debt as more dangerous since you can get yourself in trouble by charging more and may never pay off the debt.
When you pay off your revolving credit card debt with a debt consolidation loan, you have a fixed payoff date and payments. You’re less likely to get into trouble and your credit score can go up.
Avoiding late payments and having just one loan will also help you improve your credit, eventually getting you better rates and saving money on interest.
How to Get a Debt Consolidation Loan
The first thing to do before applying for any debt consolidation loans is to make a list of all your current loans and credit card balances. Include the interest rate and monthly payment on each as well as any loans that charge early payment fees.
You’ve basically got three choices for debt consolidation loans:
- Personal loans are unsecured which means you won’t have to put up your house or car as collateral. You should always pay off your loans but if you get into trouble, you won’t have to worry about losing your home. Personal loans are available for up to $35,000 and paid monthly over three to five years with companies like Avant Credit.
- Peer Lending is a new type of personal loan where you borrow directly from an investor on sites like Lending Club. You fill out an online application just like any other loan and can borrow at low rates because the bank isn’t taking their cut of the profits. Peer loans are also unsecured and usually offer terms of up to five years.
- If you have equity in your home, you might consider refinancing as a form of debt consolidation. Since it’s secured by your home, the rate on a refinance mortgage is going to be lower than personal loans. I like Quicken Loans for its low rates and easy approval process.
Check out our list of the top 10 personal loan sites for bad credit and debt consolidation for all the fees and special features of each lender.
The process of applying for a debt consolidation loan is similar across most sites. You’ll create an account and how much you want to borrow. Don’t think you need to borrow enough to pay off every loan you have but try to pay off at least the ones with high interest rates. The lender will run what’s called a “soft” check on your credit to verify your account and offer an interest rate on the loan. This doesn’t affect your credit and won’t lower your score.
If you agree to the interest rate on the loan, the online lender will run a “hard” check on your credit and you can usually get the money within a day or two. The debt consolidation loan will be deposited directly in your bank account so it’s important to pay off your individual loans as soon as possible, otherwise it’s just one more loan you have to worry about.
You will start making payments on your debt consolidation loan about a month after it gets funded. You’ll probably be paying less on your debt consolidation loan than you did on all the individual debts. Don’t just spend that money, use it to pay off your loan early.
So how much can you save with a debt consolidation loan?
Most personal loans do not have prepayment penalties so you can use the money you save through debt consolidation to pay off your loan early. This is important because it gets you in the habit of saving a little extra beyond your bills. Keep saving even after your debt consolidation loans are paid off and you’ll be able to put together a nice nest egg.
In fact, I ran the numbers on consolidating $10,000 in debt and the savings might surprise you. On $10,000 in credit cards at 24% interest, you’ll end up paying $7,261 in interest over five years. Through a debt consolidation loan at 13% interest, you’ll save nearly $5,000 and can have the debt paid off 17 months sooner if you make the same payment to your consolidated debt as you did to the individual loans.
Are there Alternatives to Debt Consolidation?
You’ve always got choices when it comes to paying off your debt. Debt consolidation loans have their benefits but there are also disadvantages.
The best alternative to debt consolidation…is just not to get into debt in the first place. Ok, it’s easier said than done. I can’t judge, I’ve been there myself.
- Closing your credit card accounts can hurt your credit score. The alternative is just to cut up your cards so you aren’t tempted to use them.
- Use debit cards so you aren’t tempted to spend more than you have in the bank.
- Use the debt avalanche or debt snowball method to pay off debt. I like the snowball method because it’s great motivation to see your smaller debts drop off fast.
- Check out my favorite books about debt payoff and credit repair.
Debt consolidation isn’t a bad thing and it’s nothing to be ashamed of using. If you could lower your monthly payments and the amount of interest you pay on loans, doesn’t it just make sense to consolidate your debt?
The one alternative to debt consolidation that you should definitely avoid is payday loans and pawn shops. It may seem like a cheaper solution because they’re only charging a $15 fee but it’s on a short-term loan and ends up working out to be over 100% interest.
Risks of Debt Consolidation Loans
Like any debt, debt consolidation loans are a tool. You need to use it for its intended purpose or you’re just going to smash things up pretty badly.
While interest rates on debt consolidation through personal loans are usually lower than credit cards and payday loans, you can still be paying hundreds of dollars in interest each year. That’s a lot of money just because you had to have that striped sweater NOW!
I looked over data on personal loans to find the interest rates for different credit scores. You can see in the graphic below that rates are way below payday lenders but can still get pretty high. If you can spend a few months improving your credit score, you can save hundreds on interest.
A debt consolidation loan isn’t so you can rush out to max your credit cards again. Consolidation loans work best when they’re combined with changing your spending habits so you don’t get over your head in debt again.
While debt consolidation loans aren’t without risks, they can be a great tool to get back on your feet and save thousands in interest. Check out some of the reviews of different personal loan sites on the blog, like this Avant review, or get started consolidating to ditch your debt.