Debt Consolidation Loans: Understand Your Options

If your debt is hard to keep up with, you may be considering debt consolidation. With a debt consolidation loan, you roll multiple debts into one. This may give you a single, monthly payment, often at a lower interest rate.

A debt consolidation loan may make sense when:

• The loan has a lower interest rate, preferably a fixed rate rather than a variable rate.
• Excluding your mortgage payment, your total debt is not more than 40 percent of your gross income.
• You have a sustainable plan in place to avoid spending more on the credit cards you are consolidating.
• You have a high enough income to cover the consolidation loan monthly payments without hardship.

How Does Debt Consolidation Work?

Let’s look at a simple example to understand how debt consolidation might work.

Imagine you have $15,000 in credit card debt across three cards, with an average interest rate of 22%. If you’re making minimum payments of about $375 per month, it could take more than six years to pay off the debt. You'd also pay about $12,000 in interest along the way.

Now imagine you qualify for a fixed-rate consolidation loan with a lower APR at 13%. If your loan payment were about $341 per month on a five-year term, you could pay off the debt in five years and pay about $5,500 in interest. That’s a savings of about $6,900.

Every situation is different. Your actual timeline and savings depend on the interest rate you qualify for, your loan term, fees, and how consistently you make payments.

To qualify for the most competitive rates, lenders typically look for a solid credit score and a manageable debt-to-income (DTI) ratio.

Types of Debt Consolidation

There are a number of ways to consolidate your debt, and each option comes with its own set of considerations. 

Personal Loans

The most common type of debt consolidation loan is an unsecured personal loan. An unsecured loan can be the right debt consolidation option, provided you get the right terms. An unsecured debt consolidation loan does not put your home at risk.

The better your credit report and credit score, the better your debt consolidation loan terms can be. You should be in decent financial shape for a consolidation loan to represent a real option for you.

Credit Card Balance Transfers

A balance transfer involves transferring high-interest credit card balances into one that offers a better interest rate and benefits. Such transfers usually have a transfer fee. In some cases, to consolidate credit card debt, the company may waive this fee.

Often, a credit card balance transfer is subject to introductory interest-free periods of up to 18 months.

The pitfall is that violating the cardholder agreement may void the introductory rate. That means that you may end up paying surprise interest charges and penalties.

Restrictions may apply, so pay close attention to all the numbers involved, including the APR and the transfer fees. In many cases, with transfer fees included, you may end up doing nothing more than breaking even or worse, paying more in the long run.

Secured Loan Options

If you’re looking to consolidate your debt, you may also be able to borrow against the equity in your home. This can help you pay off consumer debt, but it carries added risk because the loan is secured by your home. This means you could lose your home if you can’t make the payments.

Home Equity Loan

A home equity loan is a lump sum that the credit provider pays to the homeowner. Its amount depends on the homeowner’s equity (the current value of the home, minus any outstanding mortgage balance). The advantage of home equity loans for debt consolidation is they generally have a low-interest rate.

The disadvantage is that the loan terms might be able to be stretched over an extended period of time, meaning that this option may not be the quickest way to pay off existing debt entirely. Another disadvantage is that, because the home equity loan is secured by your home, you could jeopardize your home if you should default on your payment.

A HELOC (Home Equity Line of Credit)

Unlike a home equity loan, which has a fixed payment amount each month, a HELOC works like a credit card. The lender establishes an amount limit based on your home equity, as well as a time limit. Within these confines, you can borrow money as you need it.

If you are in good financial shape, HELOCs may represent a viable debt consolidation solution. Remember that a HELOC acts as a second mortgage and is, therefore, a secured loan. That means that you would jeopardize your home if you should default on your payment.

Debt Consolidation Loans vs. Debt Settlement

The Pros and Cons of Debt Consolidation

For a more detailed look at the pros and cons of debt consolidation, check out our guide.

Who Should Consider Debt Consolidation Loans?

The person best suited for a debt consolidation loan is:

In a decent financial situation with a good credit score. If your credit score is poor, you cannot get a good deal on your loan. It makes no sense to roll your burdensome debts into an even worse single package.

Responsible and disciplined. The best course of action is to avoid using the credit cards that you have paid off through the loan again. Some people find it helpful to put these credit cards aside in a space that is not easily accessible, leaving just one card with a low credit limit in their wallet in case of an emergency.

Do Debt Consolidation Loans Hurt Your Credit Score?

According to Nerdwallet, debt consolidation loans can cause a temporary dip in your credit score. This usually happens because lenders perform a hard credit inquiry when you apply for the loan.

The long-term effect of debt consolidation on your credit score can be positive, as long as you meet the terms of the loan and maintain the discipline required to avoid using credit cards that you have consolidated.

What Are the Requirements to Qualify for Debt Consolidation Loans?

To qualify for a debt consolidation loan, you need to be in decent financial shape. What this means is that:

• You have a stable work history.
• You do not pay too much in monthly minimum debt payments. Most lenders prefer a DTI below 36–45%, though some may allow higher.
• Your credit score meets the lender's requirements.
• You have decent equity to offer in the case of a secured loan.

Can a Debt Consolidation Loan Really Help You Get Out of Debt?

Under the right circumstances, it can, as long as you meet the qualifying requirements, stay disciplined, and have enough income to make the payments.

Is Debt Settlement a Better Option for You?

Debt settlement may be a better option if you don’t qualify for a debt consolidation loan. With debt settlement, debt relief companies such as ClearOne Advantage work with your creditors to try to reduce the balances of your enrolled debt.

Debt settlement focuses on lowering the total amount you owe, while debt consolidation combines multiple balances into one loan, ideally with a lower interest rate.

If you’re not sure which option fits your situation, ClearOne Advantage is here to help. To learn whether debt settlement may be right for you, speak with a Certified Debt Specialist at 888-340-4697 for a personalized debt relief plan.