To bring order to the chaos of your monthly payments, you may have come across or heard someone suggest the idea of a debt consolidation loan as a solution for debt management.
But what is a debt consolidation loan? And how does it work? Are there situations in which a debt consolidation loan can work against you? What makes a debt consolidation loan the right option for you?
Let’s break it down.
What Is Debt Consolidation?
If you have multiple ‘debts’ such as credit cards, student loans, personal lines of credit and other types of debt, consolidating this debt means combining these into one, large ‘super’ loan.
Debt consolidation means that you can make just one monthly payment, rather than several, which means you have one outgoing flow of cash every month.
This consolidated debt has one interest charge rather than several and one set of terms and conditions rather than the previous array you were facing. For example, a balance transfer — where you transfer your balance on one credit card to another one with more favourable (or zero per cent) interest rates — can be considered a form of debt consolidation.
Of course, the key to successfully using balance transfers is to make sure you pay off all the debt owed on the new card before the period of little to no interest rate expires (usually within the year).
What Is a Debt Consolidation Loan?
A debt consolidation loan can help you take a breather and focus on just one payment, payable to one party, paid once a month with one interest rate.
Technically, any form of financing that you use to pay off other debts can be considered ‘consolidating’ your debts. For example, when individuals choose to ‘refinance’ their home in order to use the money from a new home loan to pay off credit cards and personal loans, that is a form of consolidation.
There are also specific consolidation loans offered by creditors, specifically to pay off debt. Like a refinancing for debt consolidation, the debt consolidation loan then allows you to pay down the newly consolidated debt through a once-a-month payment.
These loans can be offered by financial institutions like banks and credit unions or specialised debt consolidation companies.
How Do Debt Consolidation Loans Work?
For debt consolidation loans to work in your favour, the conditions and the interest rate on the new loan you’re being offered need to actually afford you savings, over and above the ‘convenience’ of one payment.
Making three separate payments to various debts at three separate interest rates can be tricky to manage but the combined monthly payment on the debt consolidation loan must have a lower portion allocated to interest than all these three payments combined.
Why? Let’s say, for example, that you owe money on three separate credit cards.
These payments are charged an interest rate of 27.99%, 22.3% and 19.9% and, in total, you pay $650 every month. But here’s the catch: Most of the amount from those three monthly ‘payments’ you’re making is not going towards paying down your debt but, rather, paying off the interest!
This means that you’re paying just to stay afloat, rather than paying to actually make progress.
Now, imagine if you paid your same monthly payment — $650, for example — at a much lower interest rate of 11.99% once.
You’d actually be making progress towards paying off the principal amount as well as the interest.
Advantages of a debt consolidation loan
The advantages of a debt consolidation loan are clear:
- You have the potential of saving money from either a lower interest rate, a lesser amount of repayment or both because the terms on the new loan could be better (especially if you negotiate with the granting institution or creditor)
- Just one monthly repayment means you can set up auto-withdrawals or auto-repayments, directly from your bank account to your creditor, without worrying about multiple payments hitting you through the month or having an NSF
- You can end up paying off all your debt at a fraction of the cost
- Most importantly, a debt consolidation loan can grant you the luxury of time — the time to organise the rest of your finances while still actively paying off your debt
Potential drawbacks of a debt consolidation loan
There are a few things to consider
- The payment schedule of your new loan matters — you could end up paying more, over time, even if your interest rate and monthly payments are lower. This is why it’s important to compare your current payment schedule to the potential term of a debt consolidation loan.
- It could just as easily hurt your credit rating as help it — your newer, larger debt could be seen as a major risk factor. However, if you consolidate your debt and use less credit than you’re actually eligible for — this could raise your score because it shows consistent, responsible behaviour.
- Turning your unsecured debts such as credit card debt into secured debts — such as home loans — could actually jeopardise your most important assets and you could end up losing these (in cases where you’re using a home loan or refinancing for debt consolidation).
How to Get a Debt Consolidation Loan
There are two broad steps for getting a debt consolidation loan. The first is to do the math yourself and get all the information on whether a debt consolidation loan is right for you. To do this, list all your sources of debt, the monthly payment you make on each and the interest rate.
Then, crunch the numbers to find out how long it would take you to pay everything off and how much total interest you’re paying. Is this a better deal than the terms and interest on the debt consolidation loan you’re being offered?
The second step is to apply for a debt consolidation loan with a financial institution like a bank, credit union or a third-party lender. Banks such as HSBC, for example, have certain eligibility criteria that you must meet — for example, you must make an income of at least $40,000, be over the age of 18 and have a ‘good’ credit rating.
The whole idea and intent behind a debt consolidation loan is not just about shuffling money around, using a new form of debt to pay off the old ones. When you do your homework and find the right deal for you, you’ll be able to pay less money over time in a more favourable arrangement.