What is a Consolidation Loan?
If you’re struggling with debt or tired of managing multiple monthly payments, a consolidation loan could provide relief. This type of loan, also known as a debt consolidation loan, makes it possible to combine several debts — generally with more favorable terms than you had before.
Debt consolidation loans can be offered by banks, credit unions and online lenders. But while there are benefits to consolidation, it isn’t right for everyone. Here’s what you need to know.
What is a consolidation loan?
In general, a debt consolidation loan is a personal loan you use to pay off existing debt. This type of installment loan is unsecured (meaning you don’t need collateral to secure the loan) and has fixed interest rates and fixed repayment terms, generally ranging from 12 to 60 months or longer.
When you take out a debt consolidation loan, you’ll often receive funds directly from the lender, and then use that money to pay off your old debts. Some lenders, like Discover Personal Loans, can even pay off creditors directly.
Afterward, you’ll make regular monthly payments on your debt consolidation loan until it is paid off.
How debt consolidation works
|Credit card #1||Credit card #2||Credit card #3|
|Total interest paid||$1,282||$2,946||$623|
|These calculations assume your APR doesn’t change over a 60 month period.|
By the time you pay off your debt, you’d pay $4,851 in interest alone, with monthly payments totaling $247.
With consolidation, you can reduce your overall cost of repayment. Let’s assume you have an 11.81% APR, the average best offered APR in April 2020 to LendingTree users, and you still want to repay your debt over 60 months. Here’s what repayment would look like:
|Debt consolidation loan|
|Total interest paid||$3,289|
With a debt consolidation loan, you’d pay $1,562 less in interest, and your monthly payment would be $26 lower.
Consolidating your debt reduces the number of bills you pay each month. This can make juggling your bills easier. On top of that, debt consolidation loans typically have a fixed interest rate, which means that your repayment is predictable. That isn’t the case with credit cards, which have variable interest rates (which change over time).
But let’s say you just need lower monthly payments to free up cash each month — you could choose a longer repayment term. On the flipside, you could choose a shorter repayment term with higher monthly payments to minimize interest charges.
Is debt consolidation a good idea?
Whether debt consolidation is a good or bad idea depends on factors such as what your finances look like, what you hope to accomplish and the lenders you qualify for. Debt consolidation can be a good idea if you want to reduce your cost of repayment, free up cash flow or just simplify repayment.
Debt consolidation is a bad idea if it’ll only cause you to rack up more debt. For example, if you pay off credit card debt with a new loan but continue charging up your credit cards, you’ll only dig yourself deeper into debt. Further, if you only qualify for a high-interest debt consolidation loan, then it might not make sense to consolidate, as you could end up paying far more with your new loan. And if your old debt has prepayment penalties, you’ll be punished for paying off the balance early using a new loan.
- Simplify repayment. Consolidation rolls multiple debts into one new one.
- Fixed interest rate. Credit cards come with variable interest rates, which change over time according to market conditions. Consolidation loans, however, come with fixed interest rates — that makes it easier to calculate your monthly payments and total loan cost.
- Choose your repayment period. Depending on the lender and your eligibility, you can pick a repayment term of 12 to 60 months or longer. Choose a short term loan with a higher monthly payment to minimize interest charges. Choose a longer term for lower monthly payments but a higher overall loan cost.
- Potentially lower repayment cost. Debt consolidation loans may come with lower APRs than you’d see on a credit card. The top 10% of loan offers in April 2020 had an average 5.27% APR. Across all credit card offers, the average minimum APR was 15.74% in April 2020, according to LendingTree companion site CompareCards. However, your credit will heavily affect the offered APRs on consolidation loans you apply for.
- Could improve credit. Your credit mix accounts for 10% of your FICO credit score. A debt consolidation loan account with a history of on-time and in-full payments can improve your credit.
- Best for good credit borrowers. Lenders rely heavily on your credit and financial information to determine loan eligibility. If your credit’s dinged, you could see high APR offers that might not make consolidation worthwhile.
- Potentially high fees. Debt consolidation loans can come with an origination fee, an upfront charge for taking out the loan that generally ranges from 1% to 8%. You might also be charged a prepayment penalty if your old debt has one. Double-check the fee structure of your new and old debt to avoid any surprises.
- May encourage more spending. While a debt consolidation loan can help you pay off debt, that’s only the case if you make and stick to a plan for paying off what you owe. If you consolidate debt with a personal loan but continue using credit cards for purchases you can’t pay off, you might never get out of debt.
How to apply for a debt consolidation loan
Applying for a consolidation loan follows the same process as applying for a personal loan.
First, you’ll need to review your finances and credit. Determine a monthly payment you can afford to make and how long you’d like to be in debt. You should also check your credit score and review your credit reports. Accessing your credit score is easy and can be done through any number of free services, such as My LendingTree. To review your credit reports once for free every 12 months, use AnnualCreditReport.com. If you see any errors, dispute them to help boost your credit. Understanding your financial situation and credit can help you determine the lenders you can qualify with and decide what loan terms you’d like.
Research lenders and apply for prequalification. Although you can apply for debt consolidation loans through local lenders like certain big banks and credit unions, online marketplaces like LendingTree can help you research multiple lenders at once. You’ll just provide basic personal and financial information, as well as information on the loan you’re seeking before seeing offers (if you prequalify).
Prequalification doesn’t guarantee you’ll be approved for a loan, but it can help you see what kinds of loan terms you can expect.
Compare lenders and decide which to apply with. Once you’ve prequalified with a few loan consolidation companies, you can compare offers and each lender’s fee structure. Consider factors such as each loan’s APR, fees, repayment terms and borrowing limits. You should choose a consolidation loan that allows you to meet your financial goals, whether that’s minimizing repayment costs or just freeing up more cash each month.
Submit a formal application. When you’re ready to apply, be prepared to submit to a hard credit check, which will temporarily ding your credit. You should also expect to be asked by the lender to provide documentation, like your pay stubs.
Receive a loan decision. Depending on the lender, you can receive a loan decision as quickly as the same day you apply. If approved, you can expect loan funds within a few business days, depending on the lender.
Use loan funds to pay off debt. In most cases, the lender will disburse loan funds via direct deposit. You’ll then use that money to pay off the debt you want to consolidate. In some cases, you can work with your lender to have your debt paid off directly.
Alternatives to debt consolidation loans
Balance transfer credit cards
Balance transfer credit cards can be an affordable alternative to a debt consolidation loan, as they often come with an introductory 0% APR for new customers. This type of offer typically lasts 12 to 21 months and can allow you to pay off transferred balances at a deep discount. However, if you don’t repay the full balance before the introductory period ends, you’ll be charged the full amount of accrued interest, so be sure you can aggressively repay the balance.
Be prepared to pay balance transfer fees, as well. These can range from 3% to 5% of the transferred amount.
Home equity loans
Home equity loans allow you to borrow against the equity you have in your home. As a secured loan, your home is used as collateral, so you can lose it if you default on the loan, but you could see competitive APRs even if you don’t have perfect credit.
While you can expect lower interest rates than those offered on a debt consolidation loan, be prepared for fees such as application or loan processing fees, underwriting fees, lender or funding fees, appraisal fees, document preparation and recording fees and broker fees. You’ll also need at least 15% equity in your property after your loan closes to qualify for a home equity loan.
Despite these drawbacks, you can expect an overall lower fixed APR when compared to a debt consolidation loan, as well as longer loan terms and possibly higher borrowing limits, depending on your equity.
Debt management plan
A debt management plan involves seeking help from a nonprofit credit counseling agency to manage your outstanding debt. With this type of plan, you’ll deposit money each month with the agency, which then uses those funds to pay all your bills. The agency may also be able to arrange lower interest rates and payments on your accounts to make repayment more affordable, and you can expect collection calls to stop. This type of plan could last 48 months or longer.
Credit cards enrolled in a debt management plan will likely be closed except for one that can be used for emergencies or travel. Though debt management plans are great for people struggling with debt and poor credit, nearly anyone who needs these services can qualify. Plan on paying a monthly fee for these services (though it can be waived for certain customers).