How Do Debt Consolidation Loans Work?

When one has multiple debts and loans to pay off (credit card debt, personal loans, overdrafts, etc.)—with each loan carrying different interest rates, monthly payment dates, and repayment duration—it is easy to get overwhelmed. A good solution would be to combine all these loans and pay them off under a singular plan.

However, since the loans were obtained from different sources and each came with its own terms, they can’t just be combined at will. To roll multiple loans and debts together under a singular plan, you need to get a debt consolidation loan. Here’s everything you need to know about it:

How it Works

A debt consolidation loan offers people who struggle to pay off various high interest loans with a unique opportunity. They get to pay off all their loans with one big loan, and the new loan comes with a lower interest rate than the loans it replaced. Yes, they still have to make monthly payments on the new loan, but this time, it will be one payment instead of multiple.

For example, a man has 3 credit card debts—with interest rates ranging from 18% to 24%—to settle. He also has an unsecured personal loan with an interest rate of 29%. If he has a good enough credit rating (well above 700) and valuable collateral (real estate preferably), he may get a debt consolidation loan with an interest rate below 10%. As a result, the man gets to pay less than he would originally have paid on his earlier debts.

Banks and credit unions offer the best rates for debt consolidation loans, but as mentioned above, a healthy credit score and/or a collateral is needed. Some other creditors offer debt consolidation loans to people with average credit scores and averagely-valued collateral, but they charge very high interest rates (up to 45%).

NOTE: Depending on the terms of their initial loans and their credit score, some debtors may not need collateral to get a debt consolidation loan from banks and credit unions.

Reasons to get a Debt Consolidation Loan

    • Lower interest rates
    • By opting for a longer amortization period, monthly payments may be significantly reduced.
    • It simplifies finances: a single loan is easier to manage than multiple loans.
  • Unlike credit card debt, a debt consolidation loan removes the possibility of accumulating more debt.

The Right Time to Consolidate

The best time to apply for a debt consolidation loan is when your credit score is high enough to qualify you for a lower interest rate. It is also important to have a financial plan to ensure that you do not accumulate debt again, along with an income that covers your monthly payment.

The Wrong Time to Consolidate

Do not consolidate if:

    • You have a low credit rating.
    • Your debt exceeds 50% of your yearly income and you cannot pay it off in 5 years. In this case, debt relief may be a better alternative.
  • The only options available come with high interest rates. If you consolidate your debt for an interest rate over 30% and you take over 5 years to pay it off, you effectively double the size of the loan.

In conclusion, a debt consolidation loan offers a way out of crippling debt. This opportunity should be taken with both hands: get better terms, choose a payment plan that works for you, and prepare a financial plan. Without a sound financial plan and the discipline to stick to the plan, the new and improved loan may not serve you well in the end.