What Is a Debt Consolidation Loan?
- A debt consolidation loan can lower your payment, reduce your interest rate, and simplify your debt management.
- Debt consolidation loan types include home equity loans, personal loans, and balance transfer credit cards.
- The best debt consolidation loan for you depends on your credit rating, amount of debt, and homeownership status.
Consumers use a debt consolidation loan to consolidate or combine multiple debts into one. The debt consolidation loan can merge credit cards, medical bills and other types of debt. Getting approved for a debt consolidation loan typically hinges on your credit scores and income.
What Is a Debt Consolidation Loan?
What is a debt consolidation loan? A debt consolidation loan is financing with a singular purpose: consolidating debts. When you get a debt consolidation loan, you typically borrow a lump sum of money. Your lender transfers a lump sum to you when you close your loan, and you use it to pay off other loans. Consolidating should give you a lower payment, lower interest rate, or both.
The kinds of debts you could combine using a consolidation loan include:
Personal loan for debt consolidation
Private student loans
You can consolidate almost any kind of debt that has less-favorable terms than the debt consolidation loan. Most consumers consolidate unsecured debt.
A debt consolidation loan can be secured or unsecured. Whether you have a secured or unsecured debt consolidation loan, the lender can charge interest and fees. The interest rates, fees and the time frame you have to pay back a debt consolidation loan can depend on the type of loan.
Types of Debt Consolidation Loans
There are several types of debt consolidation loans, including these five ways to consolidate debts:
Home equity loan
Home equity line of credit (HELOC)
Personal loan for debt consolidation
Balance transfer credit cards
A home equity loan is a loan against your home's equity. Your equity represents what percentage of the home you (and not your mortgage lender) own. You can quickly calculate home equity by subtracting what you owe on your mortgage from the home's estimated value.
Home equity loans usually have fixed interest rates, and you can pay them back over five to 30 years. The amount you can borrow with a home equity loan to consolidate debt depends on how much equity you have, your credit scores, and your income.
A home equity line of credit (HELOC) borrows against your home's equity. It's a line of credit, not a loan. You can write checks from your credit line to pay debts, then pay back the HELOC with interest. HELOCs have variable interest rates that can go up or down over time.
Cash-out refinancing is a form of mortgage refinancing in which you take out a new home loan and draw out your equity in cash. A cash-out refi is often used to fund home repairs or improvements, but you could also use the money to pay off and consolidate debt.
A personal loan delivers a lump sum of money you can use for various purposes, including debt consolidation. Depending on where you decide to apply for a personal loan, you may be able to borrow anywhere from $5,000 to $100,000 to consolidate debt. Personal loans typically have fixed interest rates and repayment terms lasting one to over ten years.
A credit card balance transfer allows you to consolidate high-interest credit card debt by moving balances from one card to another. You open a balance transfer credit card, which has a low or 0% APR. You'd then transfer balances to the card and make payments. Almost all balance transfer cards charge a balance transfer fee.
What Is the Best Debt Consolidation Loan?
The best debt consolidation loan for you is going to be the one that allows you to consolidate all of your debts at repayment terms that suit your budget.
The goal of debt consolidation is to simplify and streamline debt repayment and get better loan terms. Debt consolidation can help you pay less interest, depending on which loan you choose.
Home equity loans and home equity lines of credit could be attractive for borrowing larger amounts if you've built up a decent amount of equity in the home. A home equity loan offers the advantage of a fixed interest rate with predictable monthly payments. On the other hand, with a HELOC, you only pay interest on the portion of your credit line you use.
Cash-out refinancing can supply cash to consolidate debts at low, fixed interest rates. However, cash-out refinancing is expensive and not the best debt consolidation option for most people. The main caveat with a cash-out refi, home equity loan or home equity line of credit is that your property secures the loan. If you can't repay what you've borrowed, you could risk losing the home.
Personal loans for debt consolidation may be a good option if you have a good credit score and need to borrow less than $100,000. The better your credit score, the lower your interest rate will be. You can, however, still get personal loans for debt consolidation with bad credit. The rate you pay may be higher, so it's important to consider whether this option could save you any money.
Finally, balance transfer credit cards can help you consolidate debt at a 0% APR. If you'd like to pay off debts interest-free, that's a good thing. However, you do have to consider how long the promotional rate will last. If you still owe a balance once the introductory rate ends, you'll have to pay interest on whatever remains at the card's regular variable APR.
How Do I Get a Debt Consolidation Loan?
Many lenders offer debt consolidation loan options. If you own a home and are considering a home equity loan, HELOC or cash-out refinance, you might talk to your current mortgage lender first. Your lender can tell you what you qualify to borrow and estimate your interest rate.
If you're looking for a personal debt consolidation loan, you can visit individual personal loan lenders online or start your search at a marketplace. Debt consolidation loan marketplaces allow you to compare rates and terms from different lenders. If you see a loan option that appeals to you, you can then take the next step and apply.
When comparing debt consolidation loan options, remember to pay attention to:
Fees, including origination fees and prepayment penalties
Closing costs if you're considering a home equity loan, HELOC or cash-out refinance loan
Loan repayment terms
With credit card balance transfer offers, you'd want to look at the APR you'll pay, how long that rate will last and the balance transfer fee. If you're considering a card that offers a 0% APR transfer for 18 months, it helps to think about whether that's enough time to pay off the balance before the regular rate kicks in.
If you've evaluated all the debt consolidation loan options and can't find a suitable solution, there are other possibilities for managing debt. For example, you could seek debt relief through a debt management plan (DMP) or debt settlement.
With a debt management plan, you make one monthly payment to a credit counselor or debt relief company. That payment is then distributed among your creditors until your debts are paid off. A debt management plan could save you money if your credit counselor or debt relief company can negotiate a lower interest rate or fee waivers on your behalf.
Debt settlement allows you to pay off debts for less than you owe. You could try to settle debts alone, but it may be helpful to work with a debt settlement company. The company can work with your creditors to reach an agreement with your creditors. The debt settlement process can take time, but it can be an excellent alternative to filing bankruptcy.
Of course. You might try a balance transfer scheme to get zero interest for 18 months and then refinance the remaining balance with a personal loan. Or roll as much debt as you’re allowed into a home equity loan and pick up the rest with a personal loan or balance transfer.
The main risk of a debt consolidation loan is that you'll create new ones after you pay off your debts with the loan. For example, you might pay off $10,000 in credit card debt using a consolidation loan, then be tempted to make new purchases on the cards. For that reason, a debt consolidation loan may only be worth considering if you're committed to not creating new debt.
A debt consolidation loan can affect your credit scores in different ways. First, applying for a debt consolidation loan adds a hard inquiry to your credit reports, which drops your score 3-5 points. But more importantly, consolidating credit card debt drops your credit utilization ratio, which can improve your credit score substantially and quickly.
Utilization is the percentage of revolving credit that you’re using. If you have $5,000 in available credit and your total balance is $4,000, your utilization is 80% ($4,000 balance divided by $5,000 available credit), which harms your credit scores. But if you pay those balances off with a debt consolidation loan, your utilization drops to zero. And if you pay them off with a $5,000 balance transfer card, your utilization falls to 40% ($4,000 balance divided by $10,000 available credit).
Debt consolidation loans are a good idea when you can get better terms on a new loan than you have on the loans it replaces.
You can replace high-interest debt with lower-interest debt.
You can lower your payments (note that this will likely increase your interest expense, and you should try to pay off debt consolidation loans as fast as possible).
You can simplify debt management by replacing several payments with one.
Are debt consolidation loans a good idea for problem spenders? Absolutely not. Debt consolidation failure usually happens when consumers transfer their balances to a new loan (debt consolidation does NOT “wipe out” debt!) and then run up their credit cards again. Then, they have the new loan plus maxed-out credit cards.
What are debt consolidation loan rates? It depends on the product and your credit rating. Secured loans like mortgages are less dependent on your credit rating than unsecured loans. Here are ranges for different debt consolidation loan products as of this writing:
Home equity loans: 5% to 10%
HELOCs (variable rate): Starting at 4%
Cash-out refinances: Starting at about 3% for a 15-year loan, 4.25% for a 30-year loan.
Personal loans: On average, personal loan rates run about 7% lower than those of comparable credit cards (24-36 month term)
Balance transfer cards: 0% starting rate, adjusted rate depends on your credit rating and the issuer