What is a debt consolidation loan?
A debt consolidation loan combines multiple unsecured debts — such as credit cards, medical bills, and payday loans — into one fixed monthly payment.
A debt consolidation loan is usually a good idea if the interest rate on the loan is lower than the combined rates of your existing debts. With this lower rate, you’ll save money on interest and possibly pay off your debt faster.
How to Choose the Best Debt Consolidation Loan
When deciding between debt consolidation loans, compare these factors.
Annual rates in percentage: The APR of the loan represents its true annual cost, as it includes all fees and interest charges. Rates vary based on your credit score, income, and debt-to-equity ratio. Use APR to compare several loans. Choose a low rate with monthly payments adapted to your budget.
Creation costs: Some lenders charge assembly costs to cover your loan processing costs. These one-time fees typically range from 1% to 10% of the loan amount and are either deducted from your loan proceeds or added to the loan balance. If the fees are deducted from your loan proceeds, you will need to ask for more than the sum of your debts in order to cover the fees and still have enough to pay your creditors.
Characteristics of the lender: Some lenders offer user-friendly features such as direct payment to creditors, which means that the lender pays off your old debts once your loan is closed, which saves you this task.
Other features worth buying include free credit score monitoring and hardship programs that temporarily reduce or suspend monthly payments if you face a financial setback, such as job loss.
How to qualify for a debt consolidation loan
Build up your credit: Loan approval is based primarily on your credit score and repayment capacity. It may be possible to get a debt consolidation loan with bad credit, but borrowers with excellent credit (720-850 credit score) have more loan options and can qualify for lower rates. If you have fair or bad credit (less than 690 credit points), it can pay for build your credit before applying for a consolidation loan.
Apply for a joint or co-signed loan: Adding a co-borrower or co-signer to your application can help you qualify for a debt consolidation loan that you couldn’t get on your own due to bad credit or low revenue. In a solidarity loanboth borrowers have equal access to the funds, unlike a co-signed loan, where only the main applicant does. Co-borrowers and co-signers are responsible for missed payments.
Compare the prices: Compare the rates and terms of several lenders before applying for a debt consolidation loan. Most online lenders allow you pre-qualified with a gentle credit inquiry, which has no impact on your credit scores.
Prepare a debt consolidation loan
Plan ahead: Before financing your loan, create a budget which allocates a percentage of your income to debt repayment.
Limit expenses: Avoid big spending on your credit cards because you repay the debt, but do not close any of the cards. Canceling credit accounts can hurt your credit score.
Commit to long-haul: Debt consolidation is a smart move for many, but it’s important to remember that debt doesn’t go away — it goes somewhere else. Most debt consolidation loans offer terms of two to seven years, so be prepared to stick to your monthly payments during that time.
Will debt consolidation hurt my credit rating?
Consolidating your debt with a personal loan can help — and hurt — your credit score. When you use the loan to pay off your credit cards, you reduce your credit utilization, which measures how much of your credit limit is tied up. Reducing your credit usage can help your credit.
On the other hand, applying for the loan requires a rigorous credit check, which can temporarily affect your credit score. And if you roll over and rack up new credit card debt, your credit score will suffer.
Late payments on your new loan can also hurt your credit score, while on-time payments can help.
How to Pre-Qualify for a Debt Consolidation Loan
Pre-qualifying for a loan online can give you access to potential loan terms, including the loan interest rate. You can pre-qualify with lenders on NerdWallet to compare offers and find the lowest price.
Other Ways to Fight Debt
A debt consolidation loan is not your only option for controlling your debts.
Credit card with 0% balance transfer: For borrowers with good to excellent credit (credit score of 690 or higher), the transfer of debt to a 0% Balance Transfer Card can be a good option, as long as you can pay it back during the introductory period.
Credit advice: Non-profit organizations provide credit counseling, which includes helping you create a debt management plan. Similar to other consolidation products, these plans consolidate your debts into one manageable payment at a reduced interest rate.
Debt repayment strategies: If you don’t know how to tackle debt, you may not need to consolidate. The debt snowball and avalanche of debt are two common strategies for paying off debt. The snowball method focuses on paying off your smallest debt first, building momentum as you go. The avalanche focuses first on paying off the debt with the highest interest rate, then applying the savings elsewhere. Both can increase your payment speed.