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What is a Debt Consolidation Loan?

November 13, 2019 by Daniel Azzoli

Two people in business suits shaking hands in front of a bookcase

Debt consolidation loans may be a way to refinance debt. The process often involves bundling multiple high-interest, unsecured debts together and then paying off a single bill over time with regular monthly payments. Some common types of unsecured debts may include medical bills, student loans, and credit card balances, but debt refinancing may not be an option for all unsecured loans.

One common type of debt where people may use a debt consolidation solution is credit card debt. Credit cards often have high interest rates and tempting “minimum payment” options; as a result, your credit card balance may become unmanageable and a snowball effect could begin. It’s important to stop this snowball effect from happening before it starts because it may be easy to lose control of the ability to pay off the monthly balance. However, in a situation where the balance has gotten out of control and the debt is unmanageable, it may be understandable why someone might consider a debt consolidation loan.

Let’s take a look at some points about debt consolidation.

Why Some People May Consider a Debt Consolidation Loan

Although debt consolidation loans still have interest rates, they may be lower than the interest rates on unsecured loans. For example, the average credit card interest rate at the beginning of 2019 was 19.25 percent for new offers and 14.14 percent for existing offers, while a low-interest debt consolidation loan may hover around 6%. There are several factors someone should to consider before applying for a debt consolidation loan. Here are four instances where they may make sense:

  1. Someone’s total income is able to cover the requisite debt payments.
  2. Their credit score is good enough to qualify for a low-interest debt consolidation loan.
  3. All of their combined debt, excluding a mortgage, doesn’t surpass 40 percent of their gross income.
  4. Efforts have been put in place to help avoid debt in the future.

How does a debt consolidation loan work to pay off debt?

Typically, a debt consolidation loan comes from a lender who lends money for the purpose of pay off existing debt with multiple creditors. Because credit cards often have high interest rates, debt consolidations loans may help reduce some of the stress that often comes with multiple high interest debts that continue to accrue interest and/or fees.

Coin jar on wooden table with coins in and next to the jar

For example, let’s say someone has three credit cards with interest rates that range between 20 and 25 percent. If their credit is good enough, they may qualify for an unsecured debt consolidation loan at 8 percent, which is a much lower interest rate than what they’re paying on each of the credit cards.

When would someone consider debt consolidation?

A debt consolidation might be considered in a situation where someone has a large amount of debt owed to multiple creditors. Often, debt consolidation becomes a viable solution if the debt is so much that keeping up with payments is difficult, but qualifying for a low-interest debt consolidation loan is viable.

What’s the difference between an unsecured loan and a secured loan?

Debt consolidation loans typically come in two different varieties: unsecured loans and secured loans.

With an unsecured loan, the lender is allowing someone to borrow money based on creditworthiness and/or various other requirements. Lenders may examine potential borrowers’ credit scores and financial history, and if they determine that someone is likely to be a reliable borrower, they may be offered a loan.

With secured loans, collateral of some sort will be required in order to “secure” the loan. This collateral could come in the form of a car, home, or another valuable asset. If the borrower can’t keep up with the loan payments, the lender may take the collateral. The collateral acts as security to ensure the lender will recover at least a portion of the debt.

What debt consolidation options exist for someone with bad credit?

With poor credit, finding a debt consolidation loan may be difficult. There may be secured loan options, but someone may not feel comfortable putting up an asset as collateral.

Those with bad credit may be able to obtain similar results as a debt consolidation loan with the following options:

What’s the difference between a debt consolidation loan and debt settlement?

With debt settlement, individuals may utilize a third-party organization to negotiate with creditors on their behalf to accept less than the total amount of their outstanding debt as repayment. What this means is that the third-party will offer the creditor some level of reimbursement and then work to “settle” the debt.

Person in suit with their hand outstretched

Creditors may potentially consider negotiating, depending on their policies, and accept less than what they’re owed, possibly to ensure that they get at least a portion of the lent money back. The debt settlement company will often contact your creditors on your behalf

There are, however, some cons you’ll want to look out for when considering debt settlement:

  1. Some creditors may not be willing to engage in negotiations with debt settlement companies in the first place.
  2. You may accrue additional debt through late fees and interest if the debt settlement company advises you to stop making payments on your debt.
  3. Even if the debt settlement company doesn’t settle all of your debt, you may still end up having to pay partial fees on that unsettled portion of your debt.
  4. If you stop making payments towards your debt but your creditors haven’t come to any agreements with your debt settlement company, the payments that you’re missing may show up as delinquent accounts on your credit reports.

Do some research and learn about debt consolidation loans

While it might be helpful for people to consolidate various debts into a single monthly payment, it’s important to only consider this option for the right circumstances. Consolidating debt just because it’s more convenient to make one payment towards debt every month isn’t good enough.

The main thing that truly keeps people out of debt is to maintain healthy saving and spending habits. If someone does end up considering debt consolidation, it would be important to avoid the spending habits that got them into various debts in the first place.

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