How Do Debt Consolidation Loans Work?
If you’re struggling to keep up with your bills, it might seem strange to take out a new loan or open another credit card account. But that’s how debt consolidation works. You get a new line of credit or a personal loan and use it to combine your debts into one account with a single monthly payment.
Debt consolidation could help you lower your interest rate and save you money. But before you do anything, it helps to do your homework.
- Debt consolidation rolls multiple debts into a single account with one monthly payment.
- By consolidating debt, you might save money on monthly payments, interest or both.
- Consolidating debt won’t erase it.
- A debt consolidation loan is a popular option to consolidate debts but not the only one.
What Does Debt Consolidation Mean?
Debt consolidation means combining some or all of your debts into one new account with a single monthly payment. It doesn’t erase your debt. But if you’re able to secure a lower interest rate, it may lead to lower monthly payments. And combining debts could also simplify how many different payments you have to make each month.
Ideally, debt consolidation can help you better manage your debt and pay it off more quickly.
How Does Debt Consolidation Work?
When you consolidate debt, you open a new line of credit or take out a loan to pay off existing debts. National credit bureau Experian® offers this example of how it can work:
Say you have a total credit card debt of $10,000, an average interest rate of 22% and minimum payments that total $400 each month. If you pay only the minimum, it would take you 184 months to pay off your debt. This means you’d end up paying $8,275.44 in interest on that debt.
Now say you pay off that debt with a $10,000 consolidation loan. It has an interest rate of 11% and a fixed monthly payment of $217. That means you can pay off the new loan in 60 months and save more than $5,200 in interest.
If the consolidated loan has a lower annual percentage rate (APR) than your other loans, you might save money. However, be aware of low APR “teaser” rates that revert to a higher APR after an introductory period—which could cost you more in the long run.
How Are Debt Consolidation Interest Rates Determined?
The better your credit scores are, the lower your debt consolidation interest rate might be.
You can check your credit for free with CreditWise from Capital One, which gives you your VantageScore® 3.0 credit score and TransUnion® credit report. If you don’t have excellent credit, CreditWise might be able to help. It gives you tips for improving your scores. It won’t hurt your scores. And you don’t even have to be a Capital One customer to sign up.
You can also learn more about getting free credit reports once a year from each of the three major credit bureaus by visiting AnnualCreditReport.com.
Debt Consolidation Loans Explained
A debt consolidation loan lets you combine multiple debts into a single monthly loan payment with the goal of saving you money while simplifying the repayment process.
If you’re considering a debt consolidation loan, you might start by comparing rates. You might be able to consolidate multiple types of debt, including credit card debt, auto loans, home loans and even medical bills.
But if you’re not improving your interest rate or payment terms, it might not be worth it. Comparing the loan offers can help you select the one that works best for your situation.
If you’re interested in a debt consolidation loan, it might be worth considering:
- If the low interest rate only lasts a limited time—and what it will be later.
- Whether there are any other fees or costs associated with the consolidation loan.
- If the loan stretches out your repayment term so much that you end up paying more in interest than you would have done without it.
Does a Debt Consolidation Loan Hurt Your Credit Scores?
In the short term, a debt consolidation loan might negatively impact your credit scores. One reason is because a debt consolidation loan requires a hard inquiry. Over the long term, however, making monthly payments on time can help your credit scores.
When Is a Debt Consolidation Loan the Right Choice?
A debt consolidation loan can be a smart move if it saves you money due to varying interest rates or if it makes it easier to track and make payments on time. Finding a lower interest rate on your current debt is one important thing to consider.
What Debt Can You Consolidate?
Several kinds of debt can be consolidated:
Credit card debt consolidation lets you combine multiple credit card balances—either with a balance transfer or a loan—and pay one monthly payment. You may be able to lower your payments if the credit card or loan has a lower interest rate than your current accounts have.
But remember: Be aware of low APR “teaser” rates. They revert to a higher APR after an introductory period. And that could cost you more in the long run.
Depending on the type and mix of student loans you have, you could consider student loan consolidation. A single loan with one servicer or lender might make it simpler to manage your debt. It might also give you a chance to get more favorable loan terms.
There might be drawbacks, though. According to the Department of Education, consolidating federal loans could cause you to lose some benefits. It could also end up increasing the total amount you owe or extending how long it takes to pay off everything.
Home Equity Loans and Lines of Credit
If you have equity in your home, you may be able to use a home equity loan or a home equity line of credit to pay off existing debt. This type of loan may offer a lower interest rate because your home is used as collateral. This could also make it risky: If you can’t pay back the loan, you could face foreclosure on your home.
There might be high closing costs with a home equity loan. And if you use your home equity for a loan, it might not be there if you end up needing it in an emergency.
Alternative Types of Debt Consolidation
There are a few other ways you can consolidate your debts.
Credit Card Balance Transfer
A credit card balance transfer lets you consolidate multiple balances into one credit card account. And if the credit card has a lower interest rate than your existing accounts do, it could save you money on interest. Remember that balance transfers usually generate a fee based on a percentage of the balance you are moving, which also must be factored into your evaluation.
Some issuers may offer low introductory rates on credit cards. If you’re in a position to pay off your debt quickly, a balance transfer might be a great option. If there is an introductory rate, just be sure you know how it works and when it ends.
If you’re interested in this option, the Consumer Financial Protection Bureau (CFPB) suggests you consider:
- How long introductory interest rates apply to transferred balances—and whether a different rate will apply to any new charges you make.
- How your rate could change over time—and what it could cost you—if you don’t pay off your debt.
- Whether there are any balance transfer fees.
- How a balance transfer could affect your credit.
Debt Consolidation Program
Another way to consolidate your debt is by working with a nonprofit credit counseling agency or debt settlement company on a debt consolidation program—also known as a debt management plan. You make one lump-sum payment each month to the company, and the company distributes it among your creditors.
But working with debt settlement companies can be risky, according to the CFPB. That’s because these companies often charge expensive debt settlement fees. They also typically encourage clients to stop paying bills altogether, which may keep you from being able to use your credit cards in the future. It can also result in late fees and other penalties.
Unless the company actually settles your debt, any savings could be wiped out by those additional costs. And your credit scores could be negatively affected, too. Ultimately, the CFPB says that debt settlement companies could leave you in deeper debt than where you started.
Before working with a credit counseling agency or debt settlement company, be sure to do your research. For example, you could check the Better Business Bureau to see whether previous customers have filed complaints against a company.
The Pros and Cons of Debt Consolidation
Considering potential advantages and disadvantages might help you decide whether debt consolidation is right for you.
Advantages of Consolidating Debt
A debt consolidation loan might be a good idea if you’re able to:
- Find a better APR or interest rate.
- Lower your monthly payments.
- Reduce how long it takes to pay down your debt.
- Use it responsibly to build your credit.
Disadvantages of Consolidating Debt
Debt consolidation isn’t right for everyone. Here are a few things to keep in mind when considering whether it’s right for you:
- Debt consolidation alone will not eliminate your debt.
- There could be upfront fees or other costs that make consolidation more expensive.
- Simplifying payments may not necessarily make the payments lower each month.
Other Considerations When Consolidating Debt
Before consolidating your debts, here are some things to consider:
- It helps to understand why you’re in debt. You can then take steps to make a budget, adjust the way you spend and potentially change your financial habits for the better.
- Your credit scores could take a hit. New credit applications could have an impact on your credit scores.
- There’s no quick fix. Some debt settlement companies might charge you upfront with the promise that they can make your debt go away. But as the CFPB explains, debt settlement companies could leave you in deeper debt than where you started.
Debt Consolidation in a Nutshell
If you have multiple debts, consolidation might be something to consider. A good way to start is by exploring the different debt consolidation options and understanding the interest rates and other costs involved.
Thinking about consolidating your credit card debt with a balance transfer? Check out low-intro APR cards from Capital One.
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