Are Debt Consolidation Loans Worth It?
In principle, the idea of a debt consolidation loan seems like a no-brainer. You take many high-interest credit cards, with varying terms and due dates, pay them off all at once, and replace them with a brand new, lower-interest-rate (preferably fixed-rate) loan. The new loan has a finite 36-60 month payback period, and your monthly carrying cost is lower. Of course, as always, the devil's in the details.
Personal finance experts will tell you it's not a great idea to pay off one debt with another — especially if you keep the retired lines of credit active. Then with your original problem seemingly "solved," you may be tempted to resume financing purchases with your now zero-balance credit cards. This violates the theory of holes, which states: "If you find yourself in a hole, stop digging."
One solution would be to cancel all of your paid-off cards except the one with the most favorable terms and the lowest interest rate — and use it only in case of a true emergency. But isn't that how most of us get behind in our payments in the first place?
A better approach — and one that avoids more debt altogether -- might be to keep that one credit card but start putting the difference between your new fixed monthly payment and your old credit card monthly minimums into an emergency fund savings account.
Keep saving until you've set aside enough money to cover 3-6 months living expenses — plus a one-time emergency expense. When you reach this point, cancel the remaining credit card because it's possible you'll no longer need it.
With the temptation issue laid to rest, let's revisit the idea of a debt consolidation loan and acknowledge that all debt consolidation loans are not created equal. To start with, there are two general types of debt consolidation loans: secured (such as a home equity line of credit -- which requires you to put your home up as collateral) and an unsecured loan (a personal loan or line of credit) that leaves your assets untouched.
Depending on your credit score, you may only qualify for the secured loan, which offers a lower interest rate and better terms. But a secured loan also puts what may be your biggest asset — your home -- on the line. Should you ever fail to make your payments the bank could foreclose on it.
Do you really want to take that risk?
On the other hand, if you have perfect or near perfect credit and qualify for an unsecured loan at favorable terms, then a debt consolidation loan could be a viable alternative to debt reduction. You must be disciplined enough to cancel your paid-off cards and fund an emergency account. But all of this assumes your credit score is high enough that you qualify for a bank loan and you're not considering a loan from a finance company. Tread carefully.
- Simplifies your debt payments by replacing multiple credit cards/loans with a single monthly loan payment.
- Reduces your financial exposure by replacing variable rate, revolving credit card loans with a “closed-ended” loan with a fixed monthly payment amount.
- Creates monthly payment savings which can either be applied to other bills or added to savings.
- Creates the opportunity to fund an emergency savings account, if you’re disciplined enough to do it.
- Could greatly increase your default risk if it’s a secured loan, collateralized by your home or other assets.
- Creates a false sense that your previous credit problems have been resolved, when they’ve just been shifted to a new loan.
- Might tempt you to start financing new purchases on your credit cards if you keep them active, compounding your debt problems.
- Your credit must be strong enough for you to qualify, preferably for an unsecured personal loan with a fixed interest rate. Most lenders require a FICO score of 650 or higher to get substantial debt-consolidation loans at low interest rates. If your score is under 650 the interest rate for the same loan could jump into the double-digit range. A credit score below 580 would likely disqualify you for this kind of loan altogether from a bank, credit union, or online lender.
- Finding the best loan opportunity could take some time, and your window might be limited.
- Debt consolidation loans can have associated costs. A $75 loan origination fee is not uncommon.