A debt consolidation loan can be a great option if you have multiple credit cards, a heavy debt burden, and decent credit. But it may not be right for everybody. If your terms are favorable, a debt consolidation loan can lower your interest rates and help you pay down your debts with greater focus. If the terms are unfavorable, this personal loan can actually come with a higher interest rate, a larger sum of overall interest paid, and a more precarious financial outlook for the borrower. In other words, you should learn as much as you can about debt consolidation loans before you apply.
First, let’s begin by pointing out that having some debt and a good credit rating does not necessarily mean that debt consolidation is the best move for you. Indeed, most Americans have some kind of debt. In fact, a 2020 study from credit rating group Experian reported that the average American carries more than $92,000 in consumer debt. This debt includes items like credit accounts and credit cards, mortgages and auto loans, student loans and personal loans. All told, most of us spend some portion of every paycheck handling these debts.
Naturally, not all debts are bad. Mortgages and auto loans are debts that ultimately become assets. Paying your credit card balance fully and regularly is a great way to build better credit. And of course, student loans are just a necessary evil for many of us. Hopefully you’re making a decent living thanks in part to your college degree.
But what happens when your debts become overwhelming? What happens when your growing balances leads to onerous interest charges that compound your debt even while you attempt to make payments? This is when you might want to consider a debt consolidation loan. A debt consolidation loan can help you get a handle on your debt, create a plan for repayment, and get out from under excessive interest charges.
So how do you know if debt consolidation is right for you? And how should you go about finding the right debt consolidation loan for your situation?
If you’re looking for a deeper understanding of how loans work in general, take a look at our Complete Guide to Personal Loans. Otherwise, read on to see if a debt consolidation loan is right for you.
What is a debt consolidation loan?
A debt consolidation loan is a personal loan that the borrower will use to consolidate multiple debts. The result is a single balance of all your debts that can be paid through monthly installments. Under the right circumstances, debt consolidation can help you organize and streamline debt repayment while lowering your overall interest payments. This can make it easier to pay off the total sum of your debt at a faster rate.
According to Credit Karma, “You can consolidate all different kinds of debt using a personal loan.” However, debt consolidation is most frequently used to help recipients manage multiple credit cards and credit accounts.
What are the benefits of a debt consolidation loan?
One key benefit of a debt consolidation loan is the potential to reduce your overall interest rate. With a favorable credit rating, you should be eligible for an interest rate on repayment that is significantly lower than the interest rate charged by your various credit accounts. And if you have certain accounts with variable interest rates, consolidation could provide a chance to lock in a fixed interest rate across your debts.
Another key benefit of debt loan consolidation is the structure it provides you in your repayment process. Essentially, says Credit Karma, “When you take out a personal loan, you agree to repay that loan on a set schedule specified in your loan agreement. Since you’ll have your loan term going in, you’ll know exactly when you’ll become debt-free if you pay on time.”
Naturally, the combined impact of these benefits is also the likelihood of boosting your credit score. By lowering your credit utilization rate, establishing a consistent repayment schedule, and ultimately chiseling away at your debt at an accelerated pace, you can expect to see relatively swift improvement in your credit rating.
What are the drawbacks of a debt consolidation loan?
The drawbacks of debt consolidation will vary depending on your financial situation and the lender who provides your loan. To the latter, debt consolidation loans come in many different forms, and they come with many different fees. From origination fees and balance transfer fees to closing costs and annual fees, Forbes warns that you should look closely at the fine print on a debt consolidation offer. Know exactly what it will cost you on top of your existing debt and interest obligations.
Forbes also warns that less than optimal borrowers could actually be saddled with higher interest rates on repayment. Forbes notes that “if your credit score isn’t high enough to access the most competitive rates, you may be stuck with a rate that’s higher than on your current debts. This may mean paying origination fees, plus more in interest over the life of the loan.”
There’s another way that debt consolidation could lead to more interest paid over the life of the loan. Because you are now repaying your loan on a predetermined timeline, and because your monthly payments are likely lower than the combined monthly payments you made before consolidation, your theoretical debt repayment schedule is now much longer. Even with lower interest rates, the sum total of interest paid could be higher at the end of this loan.
You may be able to compensate for this outcome by paying more than the minimum amount each month. However, you should also be warned that some debt consolidation loans actually have prepayment penalties for completing loan repayment ahead of schedule. If possible, seek a lender that does not impose a prepayment penalty.
When is debt consolidation a good option?
Debt loan consolidation may be a good option if you’re grappling with high interest rates and if consolidating your debts can lower these interest rates. For instance, according to Forbes, the average credit card repayment interest rate was 16.45 in 2021. Those will good to excellent credit can usually receive debt consolidation loans with interest rates below 15%.
Debt loan consolidation may be a good option if you can get a personal loan with a lower interest rate than the current rate on your existing credit accounts. This is where your credit score comes into play. If you have a credit score of “excellent” to “perfect” (720-850), Bankrate notes that you’ll likely receive a personal loan with an interest rate between 10.3% and 12.5%. This would be a marked reduction in your interest rate at even the average of 16.45%. In other words, if you have excellent credit, you have a significant amount of credit card debt, and you are paying high interest on that debt, consolidation could be a savvy move.
If your credit rating is considered “good” (690-719), the interest rate for your debt consolidation loan would likely fall somewhere between 13.5% and 15.5%. While this is lower than the average credit card interest rate, the margin of difference is much smaller. Now you’ll need to factor in considerations like fees and the total sum of interest paid over the life of the loan. Whether loan consolidation is right for you will depend on some detailed calculations. If you happen to have exceptionally high credit card interest rates—let’s say 20% or above—consolidation might still improve your outlook.
For credit scores that are considered “fair” (630-689), the conversation changes significantly. Indeed, Experian advises that debt consolidation is really only a good fit if you have a good credit score to begin with. According to Experian, “Personal loans are available to borrowers across the credit spectrum. But if you want favorable terms and a low interest rate, you’ll generally need at least a good credit score, which starts at a FICO® Score☉ of 670.”
Anything less than that will make a debt consolidation loan a poor fit for you. Your interest rates would almost certainly exceed what you’re already paying to manage your credit card debt.
Will a debt consolidation loan impact my credit rating?
Technically, debt consolidation will cause a temporary dip in your credit score but, in most cases, this dip will be followed by long-term improvements in your credit score. Nerdwallet explains that debt consolidation requires a hard inquiry into your credit history. Any hard inquiry results in a temporary decline in your overall credit score.
But if you are a suitable candidate for a debt consolidation loan, you would almost certainly see improvements as you gradually reduce your credit utilization rate. Moreover, says Nerdwallet, a favorable consolidation debt loan “Can improve credit by lowering the amount of your credit limits you’re using, if you move credit card balances to an installment loan.”
In other words, reducing the number of revolving credit accounts where you are close to your spending limit will improve your credit. Essentially, this means that the end result for most qualified debt consolidation loan candidates is a quick recovery from the hard inquiry dip followed by ongoing credit repair.
How do I get a debt consolidation loan?
You can get a debt consolidation loan by applying for a personal loan through a lender that specializes in debt consolidation. The best way to find a debt consolidation loan with favorable terms is to compare offers from several reputable lenders. Reputable lenders include entities like SoFi, Marcus by Goldman Sachs, LightStream, Best Egg and more.
To find the right lender for you, you’ll be looking at three basic factors:
-Range of APR Rates (Interest rate on repayment)
-Total Loan Amount (Sum total available to borrow)
-Loan Term (repayment timeline)
Not only are these factors different with each lender, but the actual numbers will be different for every borrower. Once again, your credit score will play a big part in determining your interest rate. For a good sense of how your credit score and other aspects of your financial outlook might impact the terms of your debt consolidation loan, consider using a personal loan calculator. Nerdwallet offers a Debt Consolidation Calculator that you can use to determine your likely eligibility for favorable consolidation terms.
Determining this in advance can help you identify fair offers when it comes time to actually shop for a lender.
What other ways are there to consolidate debt?
You actually do have a few other options if a personal loan isn’t right for you. You can consider opening a balance transfer credit card. According to Credit Karma, “Balance transfer cards often have a limited time 0% promotional interest rate that allows you to pay no interest for a few billing cycles. You may have to pay a small fee to transfer the balance, although some cards do not charge for this.”
And if you are a homeowner, you may also have the option of receiving a home equity loan. With a home equity loan, you’ll be borrowing against the value of your home to secure a personal loan. This loan can be used to pay down your debts. But there is a catch, and it’s a pretty big one. By borrowing against the value of your home, you are putting your home up as collateral. If, for any reason, you are unable to meet your loan repayment responsibilities, you could lose your home.
However, the reality is that the favorability of terms for either of these options will also depend on your credit rating. With a fair or poor credit rating, you are unlikely to receive promotional 0% interest credit card offers for balance transfer. You are equally unlikely to receive a home equity loan with a favorable interest rate.
In other words, most consolidation options depend on good credit. In the absence of a strong credit score, you may want to focus some of your energy on credit repair before applying for a debt consolidation loan.