When you move to consolidate your outstanding debts, you’ll be obtaining a new loan called a consolidation loan. You’ll pay off the old debts with the new consolidation loan and then have one payment – usually at a lower APR and for a fixed term limit of three to five years.
The lender (a bank or credit union) will pay off your existing debts with the loan you secured and you’ll now be responsible to pay off that loan and any other new debts you might incur in the meantime.
People usually opt for a consolidation loan when they would prefer a lower or fixed APR, pay only one bill rather than multiple or to pay one rate rather than rates that vary. Most types of debts can be consolidated, but people usually choose to consolidate personal loans or credit card debt.
You can choose from two types of consolidation loans – secured or unsecured. A secured loan is based on something you own that has value (an asset) and it should be worth enough to cover the consolidation loan.
An unsecured loan doesn’t require assets to back the loan, making it risky for the lender and you might end up living with a higher APR, but if you don’t have the collateral to offer, it’s a good option.
The first step in getting a handle on consolidating your loans is to gather all of the information about your debts (recent copies of loan statements and other pertinent information) and list them in a way that shows the present balance and interest rates on each credit card.
You may choose to consolidate all your debts or only certain ones such as those with high interest rates, but most prefer to consolidate all of them at the same time. Determine the total amount of the debts you’ll be consolidating and also figure the average APR on the loans by totaling the interest rates and then dividing it by the number of debts you’re consolidating.
After consulting with lenders to decide if consolidation will help you and which loan is appropriate for your situation, apply for the loan. After you’re approved for the loan, make sure you understand the terms. If your application is rejected, consider consulting with a credit counseling organization to formulate a get-out-of-debt plan.
If you get the consolidation loan, you’ll either receive a check or the amount will be deposited into your checking account. Make sure you use that money to pay off the designated debts in full. Never use the loan to make another purchase.
The terms of your consolidation loan will determine your payment and how long it will take you to pay it off in full. Most loans will be paid back in the 3 to 5 years, but some can take as many as 20 or 30 years. Just make sure you get the type of loan that’s best for your situation and that you can easily make the payments.
Pros and Cons of Using a Debt Consolidation Service
Debt consolidation services can be a big help to getting out of debt and staying out of debt. Secured consolidation loans are secured with collateral, which means it’s less risk for the lender. Unsecured consolidation loans use none of your collateral, but may charge a higher APR.
Either way, you’ll benefit from consolidating all your loans into one monthly payment with one lower APR. Secured loans will provide the lowest APR and they’re the easier of the two to obtain.
If you decide to use home equity to secure a consolidation loan, you’ll also have the advantage of being able to deduct the interest on your tax return. Unless you own a home, car or other assets such as land or a boat, you can’t apply for a secured consolidation loan.
The amount of the collateral you’re securing must be at least enough to cover the loan amount. Keep in mind that with a secured loan, the lender can seize your asset if you are found in default of the loan.
Unsecured consolidation loans don’t require collateral to secure the loan, so you might end up with a higher APR. It’s still a good way to go because you’re likely to have a lower APR than most of the debts you’re consolidating.
It’s not a good idea to get an unsecured loan through a credit card. These offers involve combining all your current credit card balances into one, new credit card which has a lower APR. This may sound like a good idea, but it’s not the best route to take for several reasons.
One reason is that the new, low APR is only temporary. After a few months, the rate changes to a higher rate. Most credit card companies who offer consolidation of loans also tack on a fee (can range from $50 to $100) for each balance you transfer from other credit cards. This can add up in a hurry.
You may also incur a lower credit score when you open a new credit card account – especially if you max it out right away. Consolidating your debts by credit card may also mean that you stay in debt for a long period of time, since most companies don’t set a certain time limit for you to pay it off.
Check with your bank and several others before applying for a consolidation loan to see which can offer the best rate. If you belong to a credit union, you may get the lowest APR rate possible. Credit unions are non-profit, but restrictions for membership are often stringent.