What is a debt consolidation loan?
A Debt Consolidation Loan combines multiple debts into one single loan with one single payment. Types of debt consolidation loans include balance transfer credit cards, personal unsecured loans, and personal loans secured with an asset like a car or home. A balance transfer credit card has a maximum credit limit, and the outstanding balance determines the monthly payments.
In a secured or unsecured personal loan, a fixed amount is borrowed and a fixed monthly payment is made over the term of the loan. In all of these cases, a borrower is taking out a new loan to pay off older loans. Often times, lenders advertise lower interest rates and lower payments in order to encourage borrowers to consolidate their debt.
Should I take out a debt consolidation loan to pay off my credit cards?
With the promise of a lower interest rate and one easy monthly payment, a consolidation loan may seem like the perfect solution to your debt problem. But before you sign on the dotted line there are a few things you will want to consider.
A consolidation loan is essentially trying to pay off your debt by taking out more debt. If you keep your credit card accounts open and do not fix the underlying issue that caused the debt in the first place, you are likely to incur additional debt instead of reducing it with a consolidation loan.
“Before taking out a consolidation loan, you may be able to free up money in your budget to put toward your own debt repayment plan,” explains Mary Hays, Financial Coach with Foresters Everyday Money member benefit.1
Start by tracking your monthly spending and identifying areas where you can reduce expenses in order to create a surplus.
If you do not have good credit, you may not be able to get the low advertised interest rate, or be approved for the consolidation loan at all. Even the balances you are planning to pay off could be dragging your credit score down if they are more than 1/3 of your available credit. Before applying, Hays recommends checking your credit report, correcting any errors, and assessing your credit worthiness.
It is also important to evaluate all the costs of a consolidation loan. While the interest rate may seem lower, this may just be a “teaser rate” that lasts for a certain amount of time. If you are not able to pay off all the debt before that point, you may end up paying more in interest that you would have on your original credit cards.
Some consolidation loans also have hidden fees, such as a balance transfer fee common with credit card offers. Additionally, if you have taken out a consolidation loan secured by your car or your home, you could risk losing that asset if you get into financial trouble and are unable to make the monthly payments.
Make sure you understand all of the terms of the offer before taking out the loan. Compare the total cost, including interest and all fees, to what you are currently paying on all of your credit cards before making a final decision.
As an alternative, and particularly if you think you may fall behind on your current payments, you can contact your creditors to request an interest rate reduction or a debt repayment plan. By tracking your monthly spending you can determine how much you can reasonably afford to pay each month, and be upfront with your creditors.
Hays explains, “The first person you speak with will likely not have the authority to approve your request, so ask for a manager and be persistent.”