Debt consolidation can help you get your finances in order by combining all your debts into one loan with a single monthly payment. This can often save you money on interest charges, and make it easier to stay on top of your debt repayment plan. If you have multiple debts and are struggling to keep up with payments, keep reading to find out how debt consolidation loans work.

There are many different types of debt consolidation loans available, each with its own set of benefits and drawbacks. It’s important to understand how these loans work before deciding if one is right for you.

What is a debt consolidation loan?

One way to deal with your debt is to take out a consolidation loan. This involves applying for a new loan that covers the amount you owe on your existing debts. Once approved, you use the funds from the loan to pay off your outstanding balances. You then make repayments on the new loan over time.

There are a few things you’ll need to consider when you’re looking for a debt consolidation loan:

Loan Type

There are many different types of loans available to consumers, each with its advantages and disadvantages. The most common loan types include personal loans, credit cards with an introductory 0 percent APR, 401(k) loans, and home equity loans. It’s important to understand how each type of loan works in order to make the best financial decision for your individual needs.

Loan term

The amount you borrow, the interest rate, and the length of time you have to repay all depend on the type of loan and your financial health. Having a longer loan term might mean your monthly payments are more affordable, but you also need to be aware of the interest rate because it will determine how much you’ll pay the lender for borrowing the funds. You might find that a shorter repayment period is ideal even though the monthly payments are higher because, in the end, you’ll pay less in interest.

Secured loans vs unsecured loans

If you’re thinking about taking out a loan, you should be aware of the different types of loans available to you. A secured loan is one where you have to put down collateral, such as your home, in order to get the loan. If you fall behind on payments, the lender can take that collateral to satisfy your unpaid balance. Unsecured options, such as personal loans and 0% APR credit cards, don’t require collateral but may have higher interest rates.

How do debt consolidation loans work?

There are many benefits to consolidating your debt into one fixed-rate loan. With one predictable monthly payment, it becomes much easier to manage your finances and get out of debt. Interest rates on debt consolidation loans are often lower than the rates you’re paying on your credit cards, so you can save money in the long run as well. If you’re struggling to make multiple payments each month, consolidating your debt could be a smart financial move.

If you’re struggling to pay down credit card debt, a debt consolidation loan could help you save on interest costs. Here’s how it works:

• Card 1 has a balance of $5,000 with an APR of 20 percent.
• Card 2 has a balance of $2,000 with an APR of 25 percent.
• Card 3 has a balance of $1,000 with an APR of 16 percent.

If you pay off your credit card balances over the course of 12 months, you’ll rack up interest costs totaling $927. However, if you take out a 12-month personal loan for the same amount owed – $8,000 – at 10 percent APR, and pay it off within one year, you’ll only end up paying $440 in interest. To see how much you could save by taking out a personal loan, try using a credit card payoff calculator and a personal loan calculator.

Benefits of a debt consolidation loan

If you’re looking to save money and simplify your monthly payments, debt consolidation may be a good option for you. Here’s a breakdown of the main benefits:

Pay off debt faster

If you’re only making the minimum payments on your credit cards, you could be stretched out for years trying to repay the debt. A debt consolidation loan may help you get on a faster track to paying it off.

Save on interest costs

If you have good credit, you may be able to get a personal loan with a lower interest rate than your credit card. As of early August 2022, the average credit card interest rate was 17.58 percent, while the average personal loan rate was 10.60 percent. This could mean significant savings on interest costs if you qualify for a lower-rate personal loan.

Simplify your monthly payments

Making a single monthly payment is much easier to keep track of than making multiple payments with different due dates. This lowers the chance of missing a payment and damaging your credit score.

Repay on a fixed statement

If you’re struggling with debt, a consolidation loan can help you get back on track. With a fixed installment loan, you’ll know exactly when you’ll be debt-free, which can motivate you to stay on track with your payments.

Risks of a debt consolidation loan

As you look to the future, it’s important to weigh your short-term needs against your long-term goals. Some people choose to consolidate debt in order to save money and streamline their monthly payments, but there are potential downsides:

It won’t solve all your financial issues

If you use a debt consolidation loan to pay off your debts, you might be tempted to start using your credit cards again. However, this could increase your overall debt and make it harder to pay down your balances. It’s important to be mindful of your spending habits so you can stay on top of your finances.

There may be some additional costs

Before taking out a debt consolidation loan, be sure to ask the lender about any fees that may apply. These can include origination fees, balance transfer fees, prepayment penalties, annual fees, and more. By understanding all the potential fees associated with the loan, you can make an informed decision about whether or not it is the right choice for you.

You may pay more in interest

There are a few ways that consolidating your debt could affect your interest payments. If you have a low credit score, a high debt-to-income ratio, or are borrowing a large amount of money, you may end up paying a higher interest rate than you would on the original debt. Alternatively, if you use the consolidation loan to lower your monthly payments by stretching out the repayment term, you may pay more in interest in the long run.

How debt consolidation loans work: Interest rates

If you’re planning on consolidating your debt, it’s important to be aware that you’ll not only be responsible for repaying the amount you borrowed, but also for paying additional interest each month. Interest rates on debt consolidation loans can vary widely, from as low as 5.99 percent to as high as 35.99 percent. Obviously, a lower interest rate will save you money in the long run, so it’s worth shopping around to find the best deal possible.

Lenders usually check these factors when deciding your interest rate:

Credit score

Do you have multiple debts that you’re struggling to keep up with? A debt consolidation loan could help you get your finances back on track. To qualify for a loan, you’ll typically need a credit score in the mid-600s.

Debt-to-income ratio (DTI)

Your debt-to-income ratio is an important factor that lenders consider when determining whether to approve a loan. A lower DTI ratio signals to lenders that you are a responsible borrower who is more likely to repay your loan on time.

Income

The lending institution will confirm your employment and verify that you earn enough to make regular payments.

If you have less-than-perfect credit, you may still be able to find a lender who is willing to give you a loan. However, the interest rate will likely be higher than if you had good credit. If this is the case, you may want to consider adding a co-signer to the loan. This person agrees to make payments if you are unable to do so. Before asking someone to co-sign, make sure they understand what they are agreeing to.

How to apply for a debt consolidation loan

Taking out a debt consolidation loan requires several steps but it will be worth it if it saves you money.

1. Understand your finances

If you want to be approved for a debt consolidation loan and get a competitive interest rate, you’ll need a strong credit score. Before applying, check your credit score to see if there are any improvements you can make.

2. Compare lenders

It’s important to shop around and compare different lenders. Interest rates, fees, loan terms, and monthly payments can vary widely, so it’s important to get quotes from multiple lenders and compare them side-by-side. The loan with the lowest interest rate isn’t necessarily the best option – you could find that you’ll pay more in fees with the lower interest rate than you would with a higher interest rate and fewer fees.

3. Get prequalified

Some lenders offer pre-approval, which allows you to see the offers you may receive before applying. Many can do a soft credit check, which means the pre-approval won’t lower your credit score. You can usually get started online and compare your rate by providing your name, physical address, email address, phone number, date of birth, Social Security number, housing, and income information, and desired loan amount.

4. Gather what you need to apply

When you’re looking to consolidate your debt, you’ll need the same information you used to get prequalified, as well as some documentation to prove your income. This could be anything from recent pay stubs and bank statements to tax returns if you’re self-employed. Some lenders might also request additional information, so it’s worth asking about documentation requirements before applying.

If you are approved for a loan, the lender will send the money to either your creditors or directly to you. Make sure that the original debt is paid off before you start working on your new loan. To avoid missing any payments, set up automatic payments or use reminders. With time and effort, you will be free of debt.

Is a debt consolidation loan right for me?

A debt consolidation loan may be the right choice for you if:

You qualify for a lower interest rate

If you have good or excellent credit, you may be able to get a lower interest rate on a debt consolidation loan than what you’re currently paying on your credit cards. This could help you save money and pay off your debt faster.

You want a predictable monthly payment

If you’re looking to consolidate your debt, a fixed-rate loan could give you predictable monthly payments to work into your budget. But make sure you can afford the amount before taking out a consolidation loan.

You want to pay a single creditor each month

Paying several creditors each month can be a scramble. You can avoid late payment fees and adverse credit reporting by only paying one creditor per month.

There are times when it may be wiser to explore other options. If your credit score is on the low end, you probably won’t qualify for a debt consolidation loan with a lower interest rate than what you already have.

If you’re struggling to keep up with multiple debts, a debt consolidation loan could help by combining all your payments into one. However, this isn’t always the best option – if you’re already tight on cash or tend to overspend, it can be hard to afford the monthly loan payment. In this case, it may be better to contact your lenders and creditors to try and arrange a more manageable payment plan.

How debt consolidation loans work – The bottom line

Debt consolidation loans can help you save money by paying off your debt balances much sooner. You would also only have to make one payment each month, which is very convenient. However, there are some potential downsides to this type of loan. First, you could incur additional costs that you didn’t have before. Second, there is a chance you’ll get a higher interest rate.

When it comes to your finances, it’s important to do what makes sense for you. Sometimes that means consolidating your debt into one loan. But it’s also important to focus on developing good money-management habits over time. By taking a close look at your situation and running the numbers, you can make the best decision for yourself and your financial future.