What is a Debt Consolidation Loan?
A Debt consolidation loan is simply a process by which you use one source of money to pay off the balance owed to multiple debtors. So, for example, you could have three credit cards with outstanding balances, a student loan, and a personal loan, all with balances that need to be partially paid out each month.
A debt consolidation loan takes care of all of these debts and rolls them up into a single, more manageable monthly payment that is often lower than the previous payments you were making combined. When done right, debt consolidation loans can help clear up your debt and improve your credit over time.
What are APRs, and How Will a Lower One Help Me?
APR is the single most important factor to consider when comparing and considering debt consolidation loans. APR refers to an annual percentage rate, and it’s not exactly the same as interest rates. Here’s the main difference:
- Interest rate: The percentage you’ll be charged by a lender for supplying you with a loan
- APR: Includes the interest rate AND any fees charged by a lender when taking out a loan
So, an APR really gives you a broader scope of how much it’ll cost you to take out a loan. What this means is that the lower the APR you can get, the less you’ll be paying out over the life of your loan. In short, a lower APR means less money paid out of your pocket. That’s good news for the borrower.
How Does a Debt Consolidation Loan Work?
Debt consolidation loans are convenient for people, whether you’re good at math or not. If the numbers have got your head spinning, here’s how it works:
Let’s say you have 3 credit cards on which you owe $1000 each.Three credit cards X $1000 each = $3000You also have $55,000 in student loans to be paid off and a private loan that you took out (to fund a dream destination vacation to the Bahamas) for $15,000. That’s another $70,000 in outstanding loans.Each month, you’ll have to pay out a certain percentage (according to the minimum payment requirements and the APR subject to the specific loan) of the amount owed to each lender. So, you might have to pay out $100 to American Express, $100 to Visa, and $100 to MasterCard. Then, you also have to pay $200 towards your student loan and another $100 towards your private loan.Altogether, these payments come out to $600 per month. The payments are deducted from your overall balance, and this continues until you’ve paid off the entire debt amount. Now, here’s how it works when you introduce a debt consolidation loan into the picture.
- You take out a new debt consolidation loan for the full amount of your debt, $73,000.
- You pay off your entire credit balance for each of the three credit cards: $1,000 to American Express, $1000 to Visa, and $1,000 to MasterCard.
- You pay off your entire student loan: $55,000.
- You pay off your entire private loan: $15,000.
Now, you’re debt-free, right? Sort of. You have no more outstanding debt. The only thing you have to pay off now is your debt consolidation loan. So, instead of having to make five individual payments each month, you’ve shrunk your debt repayment requirements down to a single monthly payment. That is helpful in two ways:
- You only have to pay off a single debtor, so your monthly payments will be significantly less than if you had to keep five individual lenders happy.
- You alleviate the headache of having to juggle five different payments with five different amounts, payment schedules, due dates, fees, and more. One payment is much more manageable mentally than five.
What’s more (and often most important), you end up paying less all around because you have lowered your interest rate.
How to Choose the Best Debt Consolidation Loan Company
Look for a debt consolidation loan provider that:
- Is offering a lower interest rate (and APR);
The most important feature is the APR. With a lower interest rate, you can end up saving considerably on your debt consolidation loan. With a higher one, you’re shooting yourself in the one good foot you have to stand on.
- Has experts to talk to;
Most of us don’t know very much about finances and how these things work. For that reason, it’s essential that you find a debt consolidation loan lender that will walk you through the whole process, answer any questions you have, explain all the terms, and be clear with you about any details that are murky.
- Is flexible;
Repayment terms, prepayment penalties, late payment fees, and more will vary from one lender to the next. Find a lender with flexible terms that you can work with for the most pleasant borrowing experience.
When to Consider a Debt Consolidation Loan
A debt consolidation loan is the right idea if you:
- Are struggling with multiple types of debt
- Want to increase your credit utilization ratio
- Want to build your credit by diversifying
Of course, it is also worth noting when it’s NOT a good idea to take a debt consolidation loan. If you are currently in major credit card debt due to irresponsible spending and you don’t intend to change these habits, walk away. While a debt consolidation loan can help alleviate your debt, it will only work if you have every intention of taking a more responsible course of action in the future. Clearing your debt quickly leaves a tempting void on your credit line, freeing up that line to more spending. If you aren’t careful, you could easily find yourself in even greater credit card debt than before you started.