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Monday, November 22, 2021

What Is a Debt Consolidation Loan?

According to Bankrate, Americans carry an average of $92,727 in personal debt

So if you’ve been juggling a few credit cards, your student loans, and that old line of credit each month, you’re in surprisingly good company.

But what if there was a way to make all of those mid-month payments and your subscription to the I-Have-to-Stretch-This-Until-Payday School of Financial Management disappear? What if financial help was as simple as just taking out a loan?

We’re about to explain the ins and outs of debt consolidation. All you have to do is keep reading.

What is Debt Consolidation Exactly?

Debt consolidation is essentially what the name says on the tin. It takes debts from several creditors and wraps them up into a  convenient, single, and once-a-month payment.

Here’s how it works:

Let’s say that you owe $5,000 on your credit card, $10,000 on your car, and $20,000 on your student loans. Instead of paying your credit card, your car, and your student loans separately every month, a debt consolidation strategy would involve taking out a $35,000 loan and using it to pay off all the others.

However, even if you’re reading that and inwardly screaming “Sign me up!”, it’s worth noting that debt consolidation doesn’t exist as its own special category in the way that “credit card” or “mortgages” might. Debt consolidation is actually a technique.

As we’ll touch on later, you could use a low-interest credit card or a line of credit to get the job done. No matter which loan you apply for, what turns your loan into a debt consolidation loan is the fact that you’re using the money to combine or consolidate, your debts.

The Benefits of Taking Out a Debt Consolidation Loan

We’ve gone over the overall strategy. And we’ve explained what debt consolidation is. But why would anyone who’s in debt solve their problems by getting into more debt? By our count, there are at least three major advantages to taking this approach:

1. Simplified Financial Management

Juggling multiple accounts on the go can be exhausting in the best of times. You have to track every penny down and every expenditure requires sitting down and doing mental calculations while saying things like, “Okay. If I buy this extra piece of food here, will I still be able to make my payment this Friday?”.

And the worst part is that you’re always in a position where one moment of forgetfulness or one insane project at work has the potential to put you in a serious financial bind.

With a debt consolidation loan, you have exactly one payment to make and one creditor. You know exactly what you’re paying and when. And that can bring an element of simplicity to your financial planning that can’t be underestimated.

2. You Can Pay Down Debt Faster

Going back to our previous example, let’s say that you’ve got four debts you’re making payments on every month. In many cases, if you were to add up those minimum payments, you’d be surprised at how much of your money isn’t going towards paying down your debt because all of the money is going towards interest.

When you have a single line of credit or a debt consolidation loan, more of your money will typically go towards paying down your debts.

Which brings us to . . .

3. You Can Save Money by Paying a Reduced Interest Rate

If you happen to owe a lot of credit-related debt, then you can see how interest rates alone could dig a serious hole into your wallet.

The thing about debt consolidation is that typically the line of credit or the personal loan will likely lower your interest. And if you can get approved for them, low interest loans can save you hundreds or even thousands of dollars in the long run.

Downsides of Taking Out a Debt Consolidation Loan

If the benefits had you nodding along but wondering where the catch is, then this section is for you. Here are some of the key risks we’ve picked up on with debt consolidation loans:

1. You Might Have to Cover Specific Costs Upfront

Taking or applying for a loan isn’t always as hassle-free as calling up the bank and paying everything off right away. You may have to pay for transferring your balance or for loan origination fees to get the process started. Depending on your calculations, you may lose out on some potential savings if you go this route.

2. You Have to Be Able to Qualify

When you apply for a loan, your lender will consider a few factors, like your income level, your payment history, and your credit utilization ratio. If you’re in financial hot water and you don’t have enough money coming in to make minimum payments as it is, there’s a chance that you may not be able to apply for an additional loan due to your current debt situation.

In fact, depending on how dire your circumstances are, you may need to look for financial assistance as opposed to a debt consolidation loan.

3. Long-Term Savings Aren’t Guaranteed

Depending on the terms of your debt consolidation loan, the interest savings advantage may not be as present as it would seem at first glance. If you’re offered a higher rate, for instance, you may actually pay more in interest throughout your loan.

However, if paying lower monthly payments over longer periods of time is a better fit for your budget, this might not be a dealbreaker for you.

How Does a Debt Consolidation Loan Affect Your Credit?

There are a few factors that impact your credit. These include details like your payment history or your new credit applications. When you apply for a debt consolidation loan, you’ll likely be taking an initial hit to your credit score.

But at the same time, your credit utilization ratio will be positively impacted by your increased credit limit. And if you make a point of paying on time every time, there shouldn’t be a negative long-term effect on your credit score if you take out a debt consolidation loan.

What are Some Debt Consolidation Loan Options?

We’ve covered the pros and cons, as well as the mechanics of debt consolidation. But what kind of loans could you pursue debt consolidation purposes?

Each loan type has its strengths and weaknesses, but here’s a quick overview of some of the more common ones:

1. Personal Debt Consolidation Loan

It is the type of loan that the majority of people believe when they come across the term, “personal loan”. This is a standard loan where you take out a single amount and you make fixed monthly payments from that point forward.

If you can land a lower-interest loan, this could be a solid debt consolidation strategy.

2. Line of Credit

This is a revolving form of credit that allows you to withdraw funds and then make minimum payments as needed. These come in both unsecured and secured forms, although if you’re able to take out, say, a home equity line of credit, you may be able to save big on interest.

3. Credit Card Balance Transfers

How this works is that if you are paying down debts on multiple credit cards, you can use this strategy to pool all of those balances onto a single, lower-interest card. If you can pay your new card off quickly, it’s not a bad strategy if you have the benefit of a promotional interest period.

4. Home Equity Loan

This is a loan type that allows you to take out a loan against the equity that you’ve established in your home. Because this option uses your house as collateral, you can often secure a much lower interest rate with this approach. The key difference between a home equity loan and a home equity line of credit, however, is that the loan involves paying the money back with fixed payments.

Should You Take Out a Debt Consolidation Loan?

When you’re drowning in debt, the idea of debt consolidation can feel like the financial equivalent of being thrown a life jacket. You get to eliminate multiple debts while saving money in the process.

However, for all the positives associated with debt consolidation, you may want to be careful about going all-in. After all, you are fighting debt with more debt when you go this route. If you can qualify, however, debt consolidation is a financial strategy that can make debt repayment significantly simpler and cheaper on your end.

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Daniyel Carlson
Daniyel Carlson is a Young Researcher in the field of Data Science & Analytics having research experience of more than 8 years. He has a Masters in Computer Engineering and currently serves as an Editorial Assistant in IGI Global, United States of America. Daniyel also holds honorary positions in the Associate Member of Institute of Research Engineers and Doctors, International Association of Computer Science and Information Technology, International Association of Engineers, Society of Digital Information and Wireless Communications.

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