When trying to deal with debt, you may be considering a consolidation loan. Debt consolidation loans can provide many benefits, however there are potential downsides.
Here is everything you need to know about this type of debt consolidation, so that you can make a fully informed decision.
Types of Debt Consolidation Loans
Put simply, a debt consolidation loan is a new loan taken out to pay off all your smaller debts. You then have only one monthly payment to make, ideally with a lower interest rate than your prior loans and debts.
Consolidation loans can either be secured or unsecured. Examples of secured loans are mortgages and car loans, where the asset (the house or car) secures the repayment of the loan. Secured loans usually attract a lower interest rate, however if you fall behind in payments, the lender can take possession of the asset, to negate the loan.
Unsecured loans do not require an asset, which places the lender at a higher risk. Many lenders require borrowers to have a good credit rating for this reason. Unsecured loans therefore incur a higher interest rate than secured loans, which may place a larger financial burden on the borrower and repayments may be difficult to meet.
Credit Repair and Debt Consolidation
Whenever you apply for a new loan, a “hard” inquiry is entered onto your credit file. This will automatically dip your credit rating. Your credit rating partly depends on your credit utilisation – the amount of debt you carry as compared to the total amount of debt available to you.
If all of your credit cards are maxed out, opening a new line of credit increases your available debt and betters your utilisation ratio. If you transfer the balance to your new loan, to maintain a good ratio, you will need to keep your previous credit accounts open after paying them off. The downside of this is that it becomes easy to build up more debt.
A huge component of your credit rating is based on your payment history. Keep making your payments every month, on time, to repair your credit.
Interest Rate vs Loan Term
Debt consolidation loans are beneficial in that your new loan may have a lower interest rate than your previous loans and credit cards. This allows you to have a more affordable monthly repayment amount.
However, it is important to understand that even with a lower interest rate, stretching out a short-term debt like a credit card or personal debt, over a long term means that you will likely end up paying more in interest over the life of the loan.
It’s a good idea to get a free credit report check before applying for a debt consolidation loan, as well as seeking free financial advice. Once you have a debt consolidation loan, ensuring you make repayments on time, and avoiding accruing new debt, will assist you in becoming debt free sooner.