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One of the most popular options for people struggling to get a handle on their debts is a debt consolidation loan. However, these products are not well understood by the general public, so we put together this guide to help you understand what a debt consolidation loan is, different types of debt consolidation loans, and how to determine if a debt consolidation loan is a good idea for you.

What is a Debt Consolidation Loan?

A debt consolidation loan is a financial product that seeks to simplify your debt while lowering the overall amount you’ll pay as well as lowering your monthly payment. You can use the money you save to help make ends meet, or to pay off your debt even faster.

Understanding How Debt Consolidation Loans Work

A debt consolidation loan works by getting a loan for the value of your current debt. The consolidation lender then uses that money to pay off your current debts with your other creditors. This effectively transfers all of your debt to a single entity. The result is that it’s easier to make payments because there’s only one payment to keep track of.

Moreover, debt consolidation companies and loans usually offer lower interest rates than your current average interest rate. This has the effect of reducing your monthly payment, as you are being charged less interest each month. Additionally, a lower interest rate also means that you’ll be paying less for your debt overall. Depending on how big your debt is, this can result in a savings of thousands or even tens of thousands of dollars over the course of your loan.

How to Get a Debt Consolidation Loan

Debt consolidation loans work by reducing your monthly payments and consolidating all of your debt into a single source. The point of this is to save money month-to-month as well as over the course of your repayment.

When considering a debt consolidation loan there are a few things you can do to improve your chances and make the process of applying easier. These steps include:

  • Making a list of all of the debts you want to consolidate
  • List the total amount for each debt you want to consolidate, along with the interest rate on that debt and the monthly payment amounts
  • Add the debts you want to consolidate to produce a total amount. This will tell you what size of consolidation loan you’ll be requesting
  • Add the monthly payments for all of the debts you want to consolidate. This will give you a good baseline to compare the monthly payments for your consolidation loan offers, allowing you to ensure you’re saving money each month
  • Make inquiries with banks, credit unions, or other lending sources to see what kind of rates they offer on consolidation loans. Keep in mind that some of these organizations don’t have a product specifically labeled as consolidation loans, in which case you’ll be applying for a personal loan
  • Compare the figures between what you pay now and what you’d be paying under the consolidation loans that the different organizations offer you

A consolidation loan is a good idea if your monthly payment and interest rate are lower than what you’re currently paying. It may take some negotiation to get the rates on your loan offers to get lower than your current interest rates, so working with a bank or organization with which you have a long-standing relationship might help the process.

An Example of a Debt Consolidation Loan

Let’s imagine an average consumer and what kinds of debts they might have, for example, our hypothetical consumer has:

  • $5,000 on a credit card with an APR of 18.9% and a $200 monthly payment
  • $2,000 on a credit card with an APR of 15.9% and a $150 payment
  • $15,000 for a college loan with a 6.5% APR and $355 per month payment
  • $5,000 in medical bills financed at 9% APR and a $150 monthly payment

This consumer is paying $855 a month on $27,000 worth of debt with an average interest rate of 9.996%

If this consumer received a debt consolidation loan for $27,000 at a rate of 6.99%, they could pay off all of their debt in 38 months, and they would pay $3,128 in interest. If they continued to pay the bills off separately, it would take 40 months and they would pay $4,722 in interest. This means that the debt consolidation loan results in being debt free 2 months sooner and savings our consumer $1,594.

Debt Consolidation Loan Companies and Their Costs

When considering a debt consolidation loan, you need to consider all of the associated fees, not just the APR. Some companies charge closings fees, service fees, early repayment fees, and other charges that can add up. There are three main options for consolidation lenders

  • Credit Unions have variable rates and are likely to have the lowest number of fees and charges.
  • Banks are another option – they have more fees and charges than credit unions, but can offer a lower interest rate than credit unions.
  • Online Lenders are another option for many consumers. Online lenders look at many factors in addition to your credit score, and they can offer the lowest APR and the highest APR. They also have the widest range of fees, with some online lenders offering practically zero fees, and others charging many different service and closing fees.

Balance Transfer Debt Consolidation Loans

Another option for consumers is a balance transfer card. These are specialized credit cards that aren’t intended for everyday use, but to pay off other debts. These cards frequently offer a lower interest rate than other types of cards, but do not offer a rate as low as you might get with a consolidation loan.

Home Equity Debt Consolidation Loans

Another option for debt consolidation is a home equity loan. This option is only available to homeowners who have enough equity in their house to borrow against. You should keep in mind that, because these loans are secured by your house, failure to pay them can result in losing your home. Therefore, you need to make sure this product really is in your best interest and that you’ll be able to meet your payments before considering a home equity loan for debt consolidation.