What is a Debt Consolidation Loan?
A single loan that replaces several other loans, making it easier to manage the debt. The new loan should have more favorable terms than the accounts it replaces – a lower interest rate, more manageable payment, or both. The debt consolidation loan can be a balance transfer credit card, a personal loan or a home equity loan.
More On What is a Debt Consolidation Loan?
Debt Consolidation Loan is a single loan that replaces several other loans, making it easier to manage the debt. The new loan should have more favorable terms than the accounts it replaces – a lower interest rate, more manageable payment, or both. The debt consolidation loan can be a balance transfer credit card, a personal loan or a home equity loan.
Here are the features, benefits and drawbacks of each solution:
- Balance transfer card – lowest cost, fastest repayment, highest monthly payment. The payment can be lowered, but there will be a balance at the end of the zero-interest period.
- Personal loan – lower monthly payment than balance transfer but higher interest expense
- Home equity loan – lowest monthly payment but longest repayment period and interest expense. This can be mitigated by prepaying the loan.
Debt Consolidation Examples
The example below demonstrates how different debt consolidation loan choices affect repayment and costs. In some cases, a combination of loans might be the best solution. You can use this debt consolidation calculator to run your own scenarios.
Mr. Consumer has four credit cards that are maxed out.
He owes a total of $12,000 with payments of $390. If he continues to make these payments, it will take him 39 months to wipe out his debts and cost him $3,242 in interest.
Here are several debt consolidation solutions he might take advantage of. Each has its advantages and drawbacks. The balance transfer card has the lowest costs but also the highest payment. The home equity loan has the lowest payment but the highest cost overall, and the personal loan splits the difference.
But wait; there’s more. Mr. Consumer could choose to use a combination of these loans to keep his payment manageable and still save on interest. He could use a balance transfer card to get 18 months interest-free to pay down the balance, and then pay that off with a home equity loan.
By using this plan, Mr. Consumer does not increase his payment and he saves almost $2,000 in interest.
Debt consolidation loans can take many forms, but they have one thing in common – every one of them can put the borrower in a worse financial position if he or she does not rein in spending. If spending habits are not changed, the consumer will continue to carry credit card balances, and will also have a debt consolidation loan to repay. This kind of borrowing is unsustainable and can result in bankruptcy.