Managing multiple debt accounts at the same time can be difficult, but you can make up for it with a debt consolidation loan. They are readily available from traditional banks, credit unions, and online lenders, and they come in two forms: secured loans and unsecured loans.
Both secured and unsecured debt consolidation loans can help you shorten your repayment period by months or even years. Also, you can save a lot of interest by getting a debt consolidation loan with a more competitive interest rate and using it to eliminate your existing debt balance.
How Debt Consolidation Loans Work
A debt consolidation loan is a personal loan used to convert multiple debt balances into a new loan product. Since the interest rate is fixed, you typically get terms ranging from 1 to 10 years and fixed monthly payments.
Ideally, the interest rate on a debt consolidation loan should be lower than what you currently need to maximize cost savings. However, if you qualify for less than the total amount you owe on your credit card and loan, you should use the loan proceeds to pay off the debt with the highest interest rate.
Here’s an example of how a debt consolidation loan can save you a lot of credit card interest:
1: $1,500 balance and 17% APR
2: $2,000 balance and 15% APR
3: $2,500 balance and 12% APR
4: $3,000 balance and 21% APR
Now let’s assume you pay off these balances within 24 months. You will spend $1,629 in interest. However, if you take out a $9,000 24-month personal loan at 8% APR, your interest expense will drop to $573.25.
You can use a personal loan calculator and credit card repayment calculator to calculate the potential interest savings on a debt consolidation loan.
How to Use Secured Loans for Debt Consolidation
Secured loans are backed by collateral, making the borrower more risky. Depending on your financial situation, they may be worth it. You can use any of these secured loan products for debt consolidation.
Guaranteed Personal Loan
It’s like a traditional loan, which may be easier to get if you don’t have perfect credit. Still, there are some downsides to consider. If you default on your loan, you may get high interest rates and risk losing your collateral.
Home Equity Loan or Home Equity Line of Credit (HELOC)
Both home equity loans and HELOCs allow you to convert a portion of your home equity, or the difference between the home’s value and what you currently owe, into cash.
When you get a home equity loan, you receive the entire loan in one lump sum and pay it back in monthly installments because the interest rate is fixed. A HELOC acts as a credit card from which you can withdraw funds when needed. You only pay back what you borrowed from the HELOC, and the interest rate is variable.
Both home equity loans and HELOCs are ideal for debt consolidation because they offer more competitive interest rates than personal loans. Also, if your home has a lot of equity, you may be approved for a large sum of money. The main disadvantage is losing your home to foreclosure if you default on your loan, as these products act as a second mortgage.
How to Use an Unsecured Debt Consolidation Loan
Unlike secured loans, there are no security requirements to be approved. There are two types of unsecured debt consolidation loans and credit card options.
Unsecured Personal Loan
This loan product allows you to consolidate debt to simplify the repayment process. You’ll get a fixed rate and more manageable monthly payments. Most lenders are good at fast approvals and financing times. However, a processing fee may be charged when taking out a loan. There may also be a prepayment penalty for repaying the loan early.
Peer-to-peer lending
Unlike personal loans, they are unsecured loans by retail investors to consumers who meet their lending criteria. Even if you don’t have perfect credit, you may qualify for a loan with fast financing. On the downside, if you have poor credit, your borrowing costs may be higher than if you took out a home equity loan. Also, some P2P loans have shorter repayment terms.
Credit card transfer
You get a low or no interest introductory period – usually up to 18 months. Paying off your high-interest credit card debt and paying it off within this window will save you a ton of interest.
How to Get a Debt Consolidation Loan
You can apply for a debt consolidation loan through a traditional bank, credit union, or online lender. Ideally, your credit score should be in the mid-600s and a debt-to-income (DTI) ratio of no more than 45% for the best chance of getting a loan with a competitive interest rate. A lower credit rating doesn’t automatically lead to rejection, but you must expect higher borrowing costs and less favorable credit conditions.
Keep in mind that each lender has unique eligibility requirements, so it’s best to do some research before you apply to make sure the lender you’re considering is a good fit.
Bottom line
Debt consolidation loans make it easier to manage multiple debt accounts, you can pay off your balance faster and save a lot on interest. Before applying, evaluate secured and unsecured loans to decide which option is the best. It’s also important to shop around, prequalify without hurting your credit score, and look at the numbers to determine if debt consolidation makes sense, or if you should wait until your credit score or your overall financial situation improves.
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