Getting a loan to pay off debt might sound counterproductive. However, it can sometimes be a smart way to go. When it comes to personal finance debt relief, taking a loan for debt consolidation can lower your monthly payments and save you money on interest charges—if you do it right. Below, we’ll take a look at loans for debt consolidation to see how they work and whether or not this might be the right move for you.
What Are Debt Consolidation Loans?
Debt consolidation combines many debts into one. The strategy usually works best with high-interest debt such as credit cards, but it can also be effective with medical debt, student loans and other types of unsecured debt. An unsecured debt is one that doesn’t require you to put up collateral to secure the loan. Collateral is something with enough value to be sold to recover the lender’s money if the loan cannot be repaid.
Getting a loan for debt consolidation with bad credit may require you to put up some form of collateral. However, you may qualify for an unsecured debt consolidation loan if your credit is good.
If you can get a consolidation loan with a lower interest rate than you’re currently paying on all of your debts, the cost of paying off those debts will be less. In many cases, your monthly payments will be smaller, too.
Types of Debt Consolidation Loans
Debt consolidation loans can take a few different forms. The most common are credit card balance transfers, home equity loans and personal loans. Each one has advantages and disadvantages to consider, so it’s important to keep the following things in mind when choosing between them.
Credit Card Balance Transfers
Here, you’ll transfer the balances of several credit cards to a single one. In exchange, the card issuer usually provides a 0% or very low interest rate for a limited time. However, there’s usually a transfer fee.
The key here is to make sure you can pay the transferred amount in full before the promotional rate expires. Also, any purchases you make with that card will be billed at the standard interest rate, which can be 25% or more.
You might also lose your promotional interest rate and be responsible for paying any deferred interest if you’re late with a payment. For some card issuers, this happens after 60 days or more of nonpayment. For others, it may be as soon as you miss your first payment.
Home Equity Loans
These can work well if your home’s market value is at least 20% higher than your mortgage. Home equity is the difference between what the house is worth and how much you owe on it. For example, if your house is worth $500,000 and the outstanding mortgage on your home loan is $250,000, your equity is $250,000. You can withdraw some or most of this money to pay off your debts.
However, the lender can force you to sell the home if you can’t make the payments. You’ll also be looking at closing costs, which can be 2% to 5% of the loan amount. The biggest draw of home equity loans is that they often have a lower interest rate than credit cards and some other types of debt, but there’s also more to lose if you fall behind on payments.
Debt Consolidation Loans
A debt consolidation loan is a personal loan that is used for consolidating debt. It can be either secured or unsecured.
If your credit score is less than stellar, you might wonder, “Can I get a loan for debt consolidation?” People who need a loan for debt consolidation with bad credit might be required to post collateral to get an interest rate low enough for this strategy to make sense. Depending on your debts’ current interest rates, this may not be necessary if you have at least a fair credit score. However, it’s possible you may need good credit or better (670+) to get rates more favorable than what you’re paying now.
What to Watch Out for With Debt Consolidation Loans
Some debt consolidation loans have teaser rates—a low introductory interest rate that increases after a set period. It’s often used to entice borrowers. Be sure to check your interest rate once the teaser rate expires.
Another thing to look at is how long the loan term is. It’s easy for a lender to give you a low monthly payment by stretching it out over many years. However, the longer you pay, the more you’ll pay in interest. This could ultimately make the debt consolidation loan more expensive than the debt you consolidate.
The Bottom Line
A debt consolidation loan can be a smart strategy for simplifying your finances and reducing the cost of your debt, but only if you understand how the loan works and what it will cost you in the long run. Before applying, take time to compare your current interest rates, watch out for hidden fees or teaser rates, and carefully choose the loan type that fits your needs. Use a debt consolidation calculator to estimate your potential savings and monthly payments.
Whether you opt for a personal loan, a balance transfer credit card, or a home equity loan, the key is to use consolidation as a tool, not a crutch, and commit to a repayment plan that moves you closer to financial wellness.
