Is A Debt Consolidation Loan Right For You?

Debt consolidation involves combining two or more loans or lines of credit into a single monthly payment. The goal is to simplify your finances and ideally pay a lower interest rate. We’ll go over the specifics of a debt consolidation loan and when it could be a good idea.

What Is A Debt Consolidation Loan?

A debt consolidation loan combines your debts into a single, manageable payment and may even offer a lower interest rate.

While you may not be able to cover every debt under one payment, the goal is to pare down the payments that you have, while ideally paying less interest over time on the debts that have been consolidated.

There are various ways you might go about this, but let’s run through an example involving a dedicated loan. Many debt consolidation loans are personal loans, which are likely to have higher interest rates than mortgage rates, but lower than what you might see on a credit card.

Let’s say you have three balances you want to consolidate: $30,000 at 17% interest, $12,000 at 21% and $9,000 at 25%. The first thing you should do is some math to determine if you’re getting a better deal with the debt consolidation than if you paid off the debts individually. We’re going to do a blended rate calculation here.

In a blended rate calculation, you first multiply each balance by the individual interest rate. You take the results of that initial calculation and add them all together. Then you divide by the sum of all the balances. Multiplying by 100 gets you to the new interest rate. If the new interest rate you get is lower than the blended rate, consolidation could be a good option.

($9,000 × 0.25) + ($12,000 × 0.21) + ($30,000 × 0.17)

_____________________________________________ × 100

($9,000 + $12,000 + $30,000)

The blended rate here comes out to 19.35%. If you plan to make a concerted effort to pay that off over a 3-year period, you’ll end up paying $1,878.49 per month including $16,625.79 interest. On the other hand, if you could consolidate that $51,000 total balance into a 3-year personal loan at 12% interest, the monthly payment is $1,693.93, but you save $6,644.32 in interest. We recommend you use this personal loan calculator to check your own numbers.

Are Debt Consolidation Loans A Good Idea?

When considering whether a debt consolidation loan is a good idea, there are benefits and disadvantages to consider.

Pros

• Potential for a lower interest rate: It’s important to always do the math on this because if you can manage the payments individually, the biggest reason to consolidate debt is to save on interest. So in any consolidation, this should be a priority.
• One monthly payment: Another big advantage is that you end up with a single payment as opposed to having to manage several payments at once and trying to figure out which ones to prioritize for quicker payoff.
• Pay off faster: Consolidating all your debts with one loan with a lower interest rate could save you enough money in terms of the minimum monthly payment that you would have extra room in your budget to put more toward the loan balance every month. This allows you to pay off the loan faster, which means interest savings regardless of the rate. It’s a double win.

Cons

• Impact on credit score: Any loan you take out is going to result in a temporary negative impact on your credit score. The idea here is that it could be an indicator to lenders that you’re overextending yourself each time you have to take out another loan or line of credit. That said, it should go up if you maintain good habits from this point forward, like making your payments on time and maintaining a low credit utilization on revolving credit lines (typically less than 30%).
• Payment must be manageable: Debt consolidation may not be helpful to you if you don’t have the funds to sustain monthly payments on the levels of debt that you have. If that’s the case, you may have to look at debt settlement with your creditors.
• No guarantee of a lower interest rate: When you run the numbers on a debt consolidation, a big key is that it should save you money somehow, ideally on the interest, but it could also make sense if it makes the monthly payment fit more easily into your budget.

When To Consider A Debt Consolidation Loan

If you’re considering a debt consolidation loan, here are some things you should think about in determining if it’s right for you.

• Do you have multiple unsecured loans with different rates? Consolidation could simplify your payment process by making everything due on one date.
• Are you able to get a lower rate by consolidating? If you’ve done a blended rate calculation, and it’s better to consolidate, go for it.
• Do you have steady income to make consistent monthly payments? It’s important to know that you can handle the payment on the consolidated debt you would be taking on.
• Are you struggling with the payments based on high rates? Being able to get one monthly payment at a lower rate could help you shore up your financial situation.
• Is your credit score high enough to qualify? To be approved for a personal loan, you’ll want a score of at least 610, but 650 or higher would get you a better rate—depending on the lender you choose. For the best terms, the higher the better when it comes to credit score.

How To Get A Debt Consolidation Loan

If you’re looking to get a debt consolidation loan, there are several steps you should take to ensure you’re ready.

Assess Your Debts

The first step you need to take is to determine how much you need to pay off your high interest debt and the monthly payment range you would be comfortable with. The second question is going to determine the term of your loan.

It’s important to think this through very carefully, because you want to pay off your debt as fast as you can at the lowest possible interest rate you can get to save money. However, you don’t want to strain your budget unnecessarily. The goal is to put yourself in a better financial position.

Check Your Credit

Make sure to check your credit score before applying. As mentioned earlier, you’ll want to be around a 650 FICO^® Score for competitive rates, but the higher you can get it, the better.

The qualifying score is going to vary from lender to lender. However, if you do end up getting denied, there are habits you can apply to improve your credit. In addition to making timely payments and having a low credit utilization, make sure you check your credit for errors. You don’t want to be penalized for something that shouldn’t be on your record.

Shop For Lenders

Any time you apply for a loan, shopping around is likely to get you the best deal. There are several factors you need to consider including interest rates and possible origination fees. While it’s natural to shop on the basis of cost, be sure to look at your options holistically. For example, a lender who doesn’t charge an origination fee may be making up for it with a higher rate.

Cost is one factor, but also consider repayment terms. As an example, different lenders will offer different term lengths so you can pay off the loan faster or slower. The important thing is going to be finding a monthly payment that fits in your budget.

Apply For The Loan

When it comes to applying for a loan, the documentation you need is going to depend on the type of income you have. Here’s a list of documents that might be used in your qualification process:

• Pay stubs
• W-2s
• 1099s
• Tax returns
• Bank statements

Although the processes are likely to be similar, every lender has their own set of requirements, so be sure to follow their instructions.

Alternatives To Debt Consolidation Loans

While debt consolidation loans typically refer to unsecured personal loans, ideally at a lower interest rate than credit cards or other high-interest debt, there are several other alternatives you can use to accomplish the same consolidating effect.

Balance Transfer Credit Card

One of the easiest things you can do to consolidate credit card debt is to open a balance transfer credit card that has a zero or low-interest introductory balance transfer offer. This way you can transfer debts between cards and pay off the balance with no interest or at a substantially lower rate.

The downside to this is that you have to have a game plan to make sure that the debt is paid off before the promotional period expires. You might have to make significant temporary sacrifices to pay off your debt within a couple of months.

Cash-Out Refinance

If you want to get an even lower rate, some of the lowest rates you can get on consolidated debt come from cashing out home equity and rolling the debt into your mortgage. A cash-out refinance will typically end up giving you a lower rate of the options discussed here because it’s secured by your home and the interest is based on a primary lien.

Mortgage rates are higher given the Federal Reserve’s desire to combat inflation, but so is every other interest rate. Credit card rates in particular tend to go up directly with the federal funds rate, so utilizing the investment in your home could be an appealing option. Let’s run through an example of that.

Let’s say you currently have a mortgage at 3.5% that you’ve paid down to a $249,000 balance. The house is worth $400,000. You then roll your $51,000 worth of debt that we talked about earlier into your mortgage, so the total balance ends up being $300,000. Of course, you’re refinancing which means new loan terms, but 8% interest is better than the rate you would get on a credit card.

Whether this or any of the other alternatives discussed below are better than a debt consolidation loan will again come down to a blended rate calculation, but instead of just comparing your credit card debt to a personal loan, you compare each of the alternatives and determine which gives you the best interest rate.

Home Equity Loan

A home equity loan could be a good option if you don’t want to touch the rate on your primary mortgage. This is a second mortgage, meaning the lender holding your first mortgage gets paid first in the event that you default on the loan. Because of this, rates on a home equity loan will be higher than rates for a cash-out refinance.

However, depending on the interest rate and the balance of each loan, the math may favor taking out a home equity loan in addition to your current mortgage rather than doing a refinance of your primary loan. A Home Loan Expert can help you keep it all straight.

These offer shorter terms than mortgages, but longer terms than personal loans. So that’s something consider as well.

Home Equity Line Of Credit (HELOC)

Home equity lines of credit are like home equity loans, but it works a little more like a credit card. Instead of a fixed interest rate and payment, you have a maximum credit limit. During a draw period, you can take out as little or as much as you need to make payments, do a home improvement or whatever else you might use it for. You only make payments on the interest.

Once the initial years of the loan are over, the balance freezes and you enter the repayment period. This involves paying back the full credit line plus interest. On a 30-year HELOC, you might have a 10-year draw period and a 20-year repayment period. Rocket Mortgage^® doesn’t offer HELOCs.

Debt Settlement

If you don’t have the credit to make the other options work, you might want to look into debt settlement. If you can no longer afford the payments that you have to make, but also can’t qualify for a debt consolidation loan of any type, you may try to negotiate debt settlement with your creditors.

The payments you make show up as “paid as agreed” on your credit report. Because this is not as good as having the loan be paid in full, your credit score could take a hit. However, it’s better than ignoring the debt completely and having it go to collections from a credit perspective.

You can negotiate on your own behalf or work with a debt settlement agency. The benefits to working with an agency are that you make one payment for everyone who agrees to the settlement. However, there’s a chance that not everyone agrees, so keep that in mind. There are both nonprofit and for-profit debt negotiation companies as well.

FAQs About Debt Consolidation Loans

Let’s finish up by answering a few questions you probably have still rolling around in the back of your mind.

Does debt consolidation hurt your credit?

The answer to this depends upon the time frame you’re thinking about. In the short term, taking out any loan will involve a slight hit to your credit. However, in the long term, your credit should improve because you’re using this as part of a strategy to more effectively manage your debt.

Can you get a debt consolidation loan with bad credit?

Getting a debt consolidation loan with bad credit may be difficult. However, there are strategies you can use to improve your credit before applying. For competitive terms, try to aim for a score of at least 650, but the higher the better.

What is the difference between a debt consolidation loan and bankruptcy?

Depending on the type of bankruptcy, your slate is either somewhat wiped clean or you’re on a debt repayment plan similar to the debt settlement we talked about. However, it’s different than the debt settlement because it’s mandated by a court.

Bankruptcy has a major negative impact on your credit score beyond almost anything else. There can also be long waiting periods to get loans in the future. A debt consolidation loan is taken out with the idea that you will use it to be able to pay your creditors, so there’s no long-term harmful effect.

The Bottom Line

A debt consolidation loan allows you to roll existing unsecured debts into one loan with the idea of continuing to pay down that debt, but at a lower rate. In order to determine if a particular debt consolidation option makes sense for you, it’s important to do a blended rate calculation to see if the rate you would get by consolidating is better than continuing to pay the bills separately.

There are various options you can look at when it comes to doing a debt consolidation, from a balance transfer or a personal loan all the way up to a cash-out refinance. The most important thing is to assess your situation before moving forward with any particular alternative.

Debt consolidation is only going to work if you can change the habits that get you into debt in the first place. That starts with keeping track and staying on budget. Rocket Money^SM can help you take control of your finances.