What is a Debt Consolidation Loan?
A bank, credit union, or lending company may offer to grant you a debt consolidation loan.
While it may seem like a good idea to wipe out your debt with a consolidation loan, in reality, you’re replacing your debt with another debt.
How Does it Work?
A debt consolidation loan allows you to pay off all of your debts immediately, in exchange for a lower interest loan either provided by a bank, credit union, or other lending company.
Debt consolidation loans can be a good choice for credit card bills and other debts with high interest rates. This is because debt consolidation loans will usually have lower monthly interest rates, allowing you to pay back your debt more manageably, or extend the time that you have to pay it off. Taking out a debt consolidation loan can have a positive effect on your credit score, since your outstanding debts or defaults will be paid off. You will have one open account, which would be the consolidation loan.
However, you must compare the total cost of taking out a debt consolidation loan. A consolidation loan provider’s interest rate may be lower than your current debt, but it is dependent on the repayment term.
Your monthly payments on the debt consolidation loan will likely be lower if you agree to a longer repayment term, such as a 5-year loan versus a 2-year loan, but you’ll end up paying more in interest for the lifetime of the loan.
The total cost of a debt consolidation loan will likely end up being more costly than the debt that you used the consolidation loan to get rid.
Debt consolidation lending rates and terms are based on your credit score. If you don’t have good credit you may end up with a longer payment plan with a higher interest rate, or you might not qualify at all.
On top of this, if you have missed payments on your current debt for quite some time, or you have high credit utilization and are looking for a debt consolidation loan, your credit score is likely too low to qualify.
Does it Affect My Credit?
A debt consolidation loan has both positive and negative effects on your credit score. Your overall credit utilization will go down since you’re essentially opening up a new line of credit to pay off your credit and loan accounts.
Of course, if you continue to spend more than you can afford on your now debt-free credit cards, you’ll just have a huge credit consolidation loan on top of your debt due to bad spending habits.
An underwriter at a credit agency might also see your history of spending which led to you getting a credit consolidation loan, and flag you as a risky debtor, leading to receiving a poor credit rating.
Pros
Replace your high-interest debts and loans with a more manageable lower-interest loan.
Debt consolidation loans can be provided by reputable banks, credit unions, and lending companies
Cons
It may be difficult or impossible to qualify if you have a low credit score.
A debt consolidation loan will cost you more than the principle balance on your loan.
A lower monthly rate requires a longer repayment plan.
A long-term debt consolidation loan requires long-term financial stability and on-time monthly payments for the duration of the loan.