Debt Consolidation

Debt Consolidation

If you have several personal loans or a large credit card debt, you have probably thought more than once about how to pay them off quickly. One option is debt consolidation, which means taking out a new loan to pay off old ones.

People who want to reduce the amount they owe, the number of companies they owe money to, and the interest rate on their personal loans need this option the most. However, it is essential to understand that it is not an option for everyone and that it can cause significant damage to your credit score.

Before you consolidate debt, you should know as much as possible about it. Therefore, we suggest you learn more about this way’s features to say goodbye to all your borrowings.

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Best Debt Consolidation Loans in 2022

What is Debt Consolidation?

If you have multiple debts, you can combine them into one big one through debt consolidation. This action aims to pay off your personal loans faster and reduce your monthly payment and interest rate.

You can choose from several options for debt consolidation:

  • Refinance your credit card debts with a balance transfer credit card.
  • Use a personal loan.
  • Take out home equity.
  • Use your 401(k) savings.
  • Start a debt management plan.
  • Refer to a credit counselor.

Read this article in its entirety to see which option is right for you and what you need to do to take advantage of it.

How Does Debt Consolidation Work?

Let’s imagine you have several loans: credit card debt, a personal loan for some purchases, and a small payday loan. You received this money from different banks, and these credits were given to you on various terms, so it is highly inconvenient and unprofitable to pay them all back.

To get out of this situation, you can start by contacting a credit counselor to see which debt consolidation option suits you best. The next step is to apply to a bank, credit union, or other financial institution and get one big loan to pay off all your previous loans.

If, in the beginning, you had three loans with different terms, now you are left with only one, which will be easier and faster to pay back.

The main challenge for you in this situation is to choose the best and most favorable option for you because often borrowers don’t calculate the final monthly payment or the price of the new loan and find themselves in an even more giant debt hole.

What are Debt Consolidation Loans?

One of the easiest and most popular ways to pay off all your debts at once is to take out a large personal loan, which is usually what is called a debt consolidation loan. Besides, entire financial institutions lend money just for this purpose and even pay off your old debts directly to your creditors.

The main advantage of this method is the lower interest rate, as personal loans have, on average, half the APR of a credit card.

However, you need to understand that this option has a clear schedule and date when all the money is due; while you can pay off your credit card debt at any time, the main thing is to pay your interest in time.

You can often see offers like this at banks, credit unions, or online lenders. On average, you need a 600 credit score or more to qualify for this option, but the final requirements depend on the financial institution where you want the money.

Many lenders have a prequalification form on their websites, which you can fill out to see what specific terms are currently available. You must provide your name, age, residential address, and Social Security Number. Besides, you should know that even a soft credit inquiry may lower your credit score briefly.

If you decide to use this option, try to find a lender that offers discounts on the interest rate to those who take a loan for debt consolidation. For example, you may consider organizations like Best Egg, LendingClub, SoFi, or Avant.

How Debt Consolidation Loans Work?

This way of paying off debts is simple – you apply to the bank for a larger loan to pay off your existing personal loans. As a result, instead of several different loans with not always favorable terms, you are left with just one loan with a fixed interest rate, usually a lower one.

Let’s pretend you have three different debts:

  • A credit card with a balance of $5,000 and a 20% interest rate.
  • A personal loan of $5,000 and a 12% interest rate.
  • Another loan of $5,000 and a 36% interest rate.

If you want to pay off these loans within three years, you have a monthly payment of $698. However, if you decide to use debt consolidation and take a new loan of $15,000 with an interest rate of 10% for the same three years, you will need to pay back $541 per month.

Moreover, consolidating debt s a good option even when you can pay $698 per month but don’t want to overpay. If your lender does not have prepayment fees, you can set aside $698 instead of $541 for a new loan and thus pay it off more than a year early!

This is why many people want to take advantage of this option. But be careful; this option only makes sense if you can get a new loan on better terms. Use the debt consolidation calculator on the lender’s website or get help from an advisor to determine if you should take this step.

When Do you Require Debt Consolidation Loan?

Such a step makes sense if all the following points are about you:

  • You want to pay off your debts quickly and are willing to not borrow money from financial institutions for the next few years.

You should be aware that getting a debt consolidation loan usually leaves a negative mark on your report and causes your credit score to drop significantly. In addition, if you decide to borrow money after that, personal loan lenders will offer you unfavorable terms, which could cause you not to pay on time and get into an even giant debt hole.

  • You have a steady income.

The decision to pay off credit card debts is the right and sensible one, but if you borrow money for this purpose, you will have to pay it back on time. This means that you will have to pay back a specific monthly payment for several years, which will be difficult if you do not have a steady income.

  • Your personal loans have very unfavorable terms.

Getting a debt consolidation loan will hurt your credit score, so do not use this option if you can normally pay back the money you borrowed on your current schedule.

  • You have been improving your credit score lately and can now get better offers from lenders.

This point is very similar to the previous one and carries the same meaning – consolidating debt is a wise decision if your new interest rate will be lower than the existing one.

How to Get a Debt Consolidation Loan?

You can use the following plan to have a better chance of getting such a loan:

  • Check your credit score and report.

Some lenders will only lend you money after a hard credit inquiry, so don’t apply without first knowing if you qualify. More often than not, your credit score should be at least 600 to be eligible.

  • Make a list of all your loans and the monthly payment to calculate the general interest you’re paying now.

You only need to know three things: the total amount you owe, the full monthly payment, and how long you have to pay all your debts. So if your new loan allows you to spend less and get your money back much faster, it makes sense to take advantage of it. Remember that you can use a debt consolidation calculator.

  • Compare different offers from lenders.

Just as it is advantageous for you to get money from the bank, it is beneficial for the bank to lend it to you because it is their income.

Therefore, financial institutions often try to make the best possible conditions to attract new borrowers and offer discounts on interest rates for auto-payment and other bonuses. In this case, your task is to choose the best offer with the lowest interest rate possible.

  • Submit your application.

To do this, you’ll need to gather all the necessary documents, such as proof of identity, address, and income, and send them to the financial institution. This process is mainly done online and does not take long.

  • If you receive the loan approval, read the agreement with the lender carefully.

Remember that you agree to abide by all the terms and conditions listed therein for the next few years. Therefore, do not sign any documents without reading them first.

  • Get the money, close any existing loans, and get confirmation from the banks that you no longer owe them anything.

Since consolidating debt is your goal, you must remember to pay off all loans as soon as you get the money. Also, check with your bank to see if you have paid off your accounts. Sometimes the remaining $20 you forgot to pay off can be a massive problem in a few years.

Eligibility Criteria of Debt Consolidation Loan

It is essential to understand that each lender has different requirements for borrowers. However, we can list some general requirements:

  • You must be a U.S. citizen or have a visa proving your right to live in the country.
  • You must be over the age of 18.
  • You must not have bankruptcy or foreclosure proceedings.
  • You must reside in one of the states where the lender operates and have proof of residency (a rental agreement or recent utility bill).
  • You must be officially employed or have income from other sources.

Also, each lender determines their borrowers’ credit score and DTI ratio. They may also use other factors like education to assess your ability to pay.

Alternatives to Debt Consolidation Loans

Of course, this option may be suitable for many borrowers, but it’s still not for everyone. As we’ve said before, it’s not right for you if you don’t have a steady income or can’t guarantee that you won’t take out new personal loans in the next few years.

There are many alternatives to this option, but each has its pros and cons. So let’s take a closer look at each of them.

Balance Transfer Credit Card

This alternative is only suitable for those who want to pay off credit card debt with a high interest rate. It means you will open a new card with lower interest rates and transfer all your debt. That way, you’ll have to pay interest each month in smaller amounts, and you can pay off the balance faster.

You can also transfer multiple credit card balances to the new card. Your main goal would be to pay your interest on time and gradually pay off your credit card balances.

The benefits of this alternative are as follows:

  • You can save money through lower interest rates.
    This is the primary goal of this variant, and your main goal, in this case, is to find a card with a better interest rate.
  • A credit card can have a 0% interest rate for the first 6 to 12 months. You could save money (hundreds or thousands of dollars) if you pay off all of your high interest debt during that time.
  • Having just one monthly payment is more convenient than multiple on time payments. If you often forget your due dates, you should take advantage of this option.
  • However, this alternative has a few disadvantages:
  • This option is only suitable for credit card debt.
  • Many banks charge the borrower a fee for the transfer of credit card balances of 3% to 5% of the transfer amount.
  • If you continue to use your credit card, such consolidation will make no sense.

Taking advantage of the 0% interest rates period and making a repayment plan in advance will be a wise financial decision.

Credit Counseling Programs

If you realize that you can’t handle your high interest debt on your own and find the best way out of your difficult financial situation, you can seek expert help. At the beginning of the journey, their services are free, as they are not legally allowed to charge money for the first consultation, so this can be an excellent option for many.

Usually, credit counselors work for nonprofit organizations and help their clients put together personalized plans to solve their financial problems. They analyze your situation, offer different options, and advise you on which is best for you.

It is important not to confuse credit counseling with debt relief agencies. The purpose of the former is to help clients become more financially literate and cope with loans in a shorter time, and they do this by talking to you, not your creditors.

At the same time, debt relief agencies do not teach you how to manage your finances better but communicate with banks to reduce the number of your loans, which does not always succeed.

You should understand that credit counseling is not a complete substitute for debt consolidation but can be the first step. For example, you can go to a counselor to see if you should use this variant or if you just need to reduce your expenses instead of taking out a new loan.

Home Equity Loan

This alternative is risky enough that we insist you calculate it carefully before using it. It’s about getting a second mortgage on your house and using that money given to you with lower interest rates to pay off all the expensive loans.

This option has the following advantages:

  • You can use it even if you have a low credit score.
  • Your interest rate will be lower than any personal loan.

However, it has many disadvantages:

  • You use your home as collateral.
    You’ll lose your property if you suddenly don’t make yours on time payments.
  • Your home could lose value. If this happens when you borrow on your home’s equity, you may owe more than your home is worth.
  • You are only adding more unsecured debt to yourself. Yes, you will pay off your old loans, but you will significantly prolong the period of your life that you will be paying off your high interest debts.

Those in an emergency should only use this alternative because losing a home is too high risk. Before deciding to use this option, carefully calculate everything and consult with experts. There may be an easier and safer way out of your situation.

401(k) Loan

This alternative is also best used only if you are in dire need because it is money you can borrow from your retirement account for up to 5 years. You must have been officially employed for more than two years and not change your job for the duration of the payout.

The advantages of this alternative are as follows:

  • You will need to pay less interest rates than personal loans or a credit card.
  • You can take advantage of this option without hurting your credit score.
  • The interest you pay will go to your account.

However, there are a few drawbacks as well:

  • You’re taking your own money out of your savings. If you don’t pay it back in time, you create problems for yourself in the future.
  • You cannot leave your employment until you pay back that loan.

Many things can go wrong because you have to decide five years in advance. So if you can avoid this option, it’s best to do so.

Cash-out Refinance

This alternative will only work for those whose home has increased in value since they took out their first mortgage. This process means you get a larger loan on your home, pay off the old loan, and keep the cash you can spend on debt consolidation.

Let’s say you have a $200,000 mortgage, and your house is worth three times that of $600,000. In that case, you have $400,000 in a home equity loan. Suppose you choose cash-out to refinance and have to leave at least 20% equity in your home at the lender’s request, meaning you can borrow $320,000.

That way, you get a large amount of money at a low APR, but you must consider that your monthly payment will be higher as the amount owed increases. In addition, by this action, you are extending your loans for several more years or decades and can still lose your home if you don’t pay the money back on time.

Debt Management Plan

This name refers to a counseling agency’s plan to help you get out of debt. It involves you paying this nonprofit credit counseling agency every month, and it uses virtually all of these funds to pay off your loans according to a schedule you have agreed to in advance.

It is essential to understand that a debt management plan is not a complete alternative to debt consolidation; it is just professional help to pay off your debts. This option is more suitable for those who have enough money to pay back their loans but cannot manage their finances properly or forget to pay all their bills on time.

A debt management plan has several advantages:

  • If you use counselors, your credit score won’t decrease but will increase over time.
  • You don’t need to open new credit.
  • You can stop working with the company at any time.
  • The nonprofit credit counseling agency can negotiate with your lenders to reduce your interest rate, which will help you repay the money you borrowed faster.

However, to use this method, you will have to close your credit card accounts and use them only in case of an emergency. You also pledge not to take out new loans, and if you miss payments or credit card bills, the agency’s arrangement with your lenders to reduce your interest rate may be canceled, and you won’t save money.

Debt Settlement

If you realize that you cannot pay back the loan in full, you can contact special agencies that will try to reduce your debt or interest rate on your behalf. Their main argument is that the borrower should pay some of the money than pay nothing. Unfortunately, as you understand, this argument does not always have the desired result.

This alternative is more advantageous because if the agency can reduce the size of your loan, you will save money. However, it has quite many disadvantages:

  • The agency can ask you to stop paying your loan, which will harm your credit score.
  • Overdue monthly payments will remain on your credit report for seven years, representing you poorly as a potential borrower.
  • Debt settlement agencies are not free; they can cost you up to 60% of the total debt.
  • Debt settlement takes a lot of time and effort; it can take years.
  • You never know if the agency will be able to negotiate with the lender or if you will waste money and time.
  • There are a lot of companies on the market that cheat people and promise guaranteed results 100% of the time.

In general, you need to be very careful with this alternative and only use it if you have no other less risky options. You need to understand that in the end, with agency fees, taxes, and miscellaneous fees, you could end up paying more than you originally owed.

Bankruptcy

Bankruptcy is a way to get out of debt, unpaid credit cards, and rent. However, it should be noted that if you use this method to get rid of loans, you will not be able to borrow money again from financial institutions for the next seven years. In addition, bankruptcy can only eliminate unsecured personal loans, not secured ones.

Bankruptcy has several advantages:

  • You won’t have to pay off most of your debts.
  • You will be able to start over and get a fresh start.
  • You will no longer get calls from creditors and debt collectors.

However, it has many more disadvantages:

  • Your credit score will be much lower because of bankruptcy, a mark on your credit history.
  • You are unlikely to be able to borrow money on weekend terms until this negative mark disappears from your credit report.
  • You will have to pay court fees, attorneys fees, etc.
  • You will lose the ability to use your credit card, as you will have to close your existing accounts.

Of course, if you have to choose between consolidating debt or declaring bankruptcy, it is better to do the first. This way is always better than bankruptcy and safer.

Do Debt Consolidation Loans Affect your Credit Score?

The answer to this question depends on which method is used to consolidate debt. Let’s look at a few options:

  • You took out a new personal loan.

Debt consolidation loans hurt your credit score for the first 6 to 12 months. However, it will increase over the long term.

  • You have chosen to consolidate debt with balance transfer credit cards.

This option will also cause your credit score to drop slightly, but if you do not miss any monthly payments on the new card, it will increase over the next few months.

  • You have gotten a home equity loan.

In that case, your credit score will fall because of increased credit utilization and DTI ratio. However, your credit score could go up if you pay off all of your existing personal loans and pay the new ones on time.

  • You have enlisted the help of experts to put together a debt management plan.

Getting help from experts won’t have any effect on your credit history on its own. However, if you decide to get a consolidation loan or take advantage of any options listed above, you will still see a drop in your credit score.

  • You decide to use a 401(k) loan.

This is the only way of debt consolidation that does not show up on your credit history and therefore has no effect on your credit.

What are the Risks of Debt Consolidation?

There are several significant risks you should be aware of before deciding to consolidate debt:

  • There is no guarantee that you will be able to find a better personal loan or a credit card balance transfer.
  • You can severely damage your credit score.
  • Many lenders charge an origination fee of up to 8% of the consolidation loan amount; a credit card balance transfer may charge up to a 5% transfer fee.
  • You could lose collateral if you take out a secured loan to consolidate debt.

Before you decide on debt consolidation, make sure you calculate all your options. If you hesitate to use this option, ask a credit counselor first-their first consultation is usually free.

How to Choose the Best Loan for Debt Consolidation?

If you have already decided that you want a loan, you need to make every effort to find the most advantageous loan or credit card. To do this, you can use the following plan:

  • Choose which debt consolidation method you want to use.

Do you want to take out a personal loan or transfer your debt to a 0% APR credit card? Can you take out a home equity loan or cash refinance? Analyze all your options and choose the one that works best for you.

Remember that:

  • Unsecured personal loans are often the best and safest option for debt consolidation.
  • You can choose a transfer balance credit card if you need to pay off your credit card debt, and you are sure you can do it in a reasonable amount of time.
  • You should not take secured loans if you are unsure of your income stability. The same goes for home loans, which can lead to a debt trap.
  • If you’re having trouble determining the best option, seek help from financial experts.
  • Determine if you qualify for lenders.

You must prove your creditworthiness to get a loan with a low APR or a credit card with a 0% introductory interest rate. Lenders want to see that you will make your monthly debt payments on time so that they will look at your credit history, income, and DTI.

  • You should find out your credit score and other indicators that banks look at so that you do not apply to financial institutions that do not work with this type of borrower.
  • Evaluate the offers from different lenders that are available to you.

Many lenders allow you to fill out a pre-qualification questionnaire so you can see what offers are available to you. Be sure to take advantage of this opportunity, as banks’ websites often list the best rates, not the ones available to the average borrower.

  • List at least three of the best options and compare them.

The leading indicators you should look at are the APR, the term of the loan, the presence of penalties and additional fees, discounts, and various features.

  • Calculate whether you will save money if you take out the loan.

Read in your contract how much is the origination fee and APR, and calculate whether it is worth it. To do this, compare your current one monthly payment with the one monthly payment you will make after debt consolidation.

How Do I Qualify for a Debt Consolidation Loan?

This loan is essentially no different than a regular personal loan, so to get it, you will need to provide standard information about yourself and your financial situation. Each lender sets its requirements for borrowers, but we’ve summarized them and realized that you’re very likely to be able to get the money if:

  • Your income exceeds $20,000 per year.
  • Your credit score exceeds 600 FICO points (or at least 580).
  • You have a stable place to live and can provide proof of that.
  • You are legally employed.
  • You are a U.S. citizen or have a visa to reside there.
  • You are over 18 years of age.

In addition, some lenders may ask you to answer a few questions about yourself, including your education, marital status, etc. They need this to get a general impression of your ability to pay.

How to Check if a Debt Consolidation Company is Legitimate?

Several red flags can help you recognize scammers among debt consolidation companies. We have compiled them all into one list:

  • The company promises to reduce the amount you owe.

You can be sure that this is a lie because debt consolidation does not involve reducing the amount you owe but repaying it with a new consolidation loan. Remember that a debt settlement or interest rate reduction can be made by a debt settlement or debt relief company.

  • The company asks you to pay in advance for their services.

Usually, only scammers ask you to pay anything before you get the results. Remember that you can only pay balance transfer or origination fees in such a case.

  • The company does not tell you the terms of the collaboration before you pay.

Remember that with honest organizations, everything is transparent; they do not need to hide the conditions of cooperation, terms, or prices of their services.

  • The company will call you first with an offer to consolidate debt.

Large organizations do not need to call you to become their client, but different scammers can get your number and send you similar offers.

To avoid scams, you’d better take the time to do a little research about the company on the internet. We recommend you check the company’s name through the Better Business Bureau, study the information on their website, and look for reviews on independent sites.

Pros and Cons of Debt Consolidation Loans

Deciding to deal with debts in this way has several significant advantages:

  • You pay off all your debts faster.

This method’s main advantage is that it encourages people to do debt consolidation.

  • You are no longer afraid of late monthly payments because of the large number of loans.

Users often forget the due dates and, therefore, pay late fees. After debt consolidation, this problem will not bother you anymore as you will have only one consolidation loan to pay.

  • You will improve your credit score.

In the first months of debt consolidation, it may drop slightly, but over the next year, you will see a steady rise in your credit score if you do not miss monthly payments on your new consolidation loan.

However, we cannot forget the disadvantages you should be aware of before taking advantage of this offer:

  • Debt consolidation will not solve all of your financial problems.

You’ll need to change your spending habits and learn how to manage your income better so that you no longer take out loans that lead to a debt trap.

  • There may be up-front costs.

Depending on the option you decide to use, you may have to pay balance transfer or origination fees, closing costs, etc.

  • If you have not improved your credit score, you may not be able to find a low-interest personal loan.

Sometimes debt consolidation loan rates are higher than your existing ones. So if you want to get the most out of this offer, you need to find the best loan and pay it off over several years.

Summary

Debt consolidation is a good choice for those whose credit history allows them to take out a new loan on more favorable terms and pay off all the old money. This way, you can combine several loans into one with fixed monthly payments and a clear repayment schedule.

Your credit score will drop once you get a new personal loan, open balance transfer credit cards, or another debt consolidation loan. But you should know that over time it will rise and become even higher than before the consolidation if you make your monthly payment on time.

Most importantly, calculate all your options and ensure that your consolidation loan will help you get out of debt faster. If you are unsure of your competence and are afraid that you will select an unprofitable offer, contact a credit counselor – their first consultation is usually free.

FAQ

Can I get a debt consolidation loan with poor credit?

Yes, whole institutions give consolidation loans to people with bad credit scores. However, you must understand that such offers have a higher interest rate and a shorter repayment period. Therefore, before using them, calculate whether an unsecured personal loan will make it easier and faster for you to pay off your debts. If not, you may be better off with secured loans.

What is the average fee for debt consolidation?

The average fee, in this case, is 4% for loans and 2.5% for transferring credit card balances. Consider these fees when calculating whether a debt consolidation loan benefits you.

Do debt consolidation loans give you money?

The answer to this question depends on the lender who gives you the money. Some pay your old creditors directly, and you don't get cash, while others just make it out as an unsecured or secured personal loan and transfer the money to your bank account.

How long does debt consolidation stay on your credit report?

Such marks remain on your report for seven years and can cause your credit score to drop by 100 points. However, remember that if you make your monthly payment on your new consolidation loan on time, you will improve your credit score within 6-24 months.

Do you lose your credit cards after debt consolidation?

No, you can only lose your accounts if you go bankrupt. If you take out a personal loan to pay off your debts or get a balance transfer credit card, you don't need to close your accounts – the balance on your old credit card will simply become zero.

What credit score is needed for debt consolidation?

The specific lender always sets the minimum credit score, but we can tell you that you need to have a minimum of 600 FICO points to qualify. If you want a better chance, try raising your score to at least 650.

Can I still use my credit card after debt consolidation?

You can use your credit card legally; it is not prohibited, as all your accounts remain open even after full repayment. However, you should understand that debt consolidation makes sense only if you stop taking out new personal loans and using your old credit card.

Can you be denied debt consolidation?

Yes, the lender may reject your application and not give you an unsecured personal loan or any other debt consolidation loan. Financial institutions do this often because borrowers already have too much credit, their debt to income ratio is too high, their credit score is too low, or they do not earn enough money to make the monthly payment on time.

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