Many U.S. families are struggling under a heavy debt load that affects almost every facet of their lives — they live in constant fear that some of their property will be repossessed or that their utilities will be shut off.
They dread the time when the mail arrives, or when they receive a phone call from an unknown number, as it may be from a bill collector. Their credit scores are being dragged down and meeting their financial obligations has become a real balancing act.
According to one source, the average household has at least three credit cards, with each card carrying a balance of $4,427 for a total credit card debt of more than $13,000. Many borrowers only pay the minimum amount due each month. This can result in hundreds or even thousands of dollars in additional finance charges over the course of a year. In such cases, a debt consolidation loan may provide financial relief by lowering monthly payments. If you’re considering a debt consolidation loan, here are some things that you should know.
What Is a Debt Consolidation Loan?
A debt consolidation loan is a type of loan that provides enough money to pay off multiple debts by combining them into a single loan with one monthly payment. The new loan often will come with a reduced interest rate as well as a lower monthly payment. In addition to saving a significant amount of money in finance charges, this can help a person pay off the loan quicker. Typically, a debt consolidation loan is used to pay off unsecured debts such as credit cards, payday loans, and medical bills. Lending agencies often are willing to make this type of loan because it improves the chances that they will be able to collect on an existing loan.
Debt consolidation loans can be made on a secured or unsecured basis. For a secured loan, the borrower pledges certain assets for collateral, such as a vehicle, a house, or stock certificates. Secured loans usually carry a lower interest rate than unsecured loans, which are not backed by the borrower’s assets. Regardless of whether the debt consolidation loan is secured or unsecured, the original debt is not eliminated—it simply is transferred to the new loan. In most cases, debt consolidation loans are made for a term of three to five years.
Benefits and Disadvantages
If you’re considering a debt consolidation loan, you should be aware that such a loan has benefits and disadvantages.
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The main benefit that you would receive is that you would have only one loan, one monthly statement, and one monthly payment instead of several. This can make it easier for you to create and maintain a budget, plus it can help you to keep track of due dates so that you can make your payments on time. The payment amount on the new loan will remain the same until the loan is paid off. It will not vary from month-to-month like many credit card payments do.
In some cases, the debt consolidation loan will carry a lower interest rate which can save you money and make it easier for you to pay off the loan. Making your payments on time also will help to improve your credit score. One additional benefit of a debt consolidation loan is that the interest may be deductible on your taxes, especially if it’s secured by real estate.
The main disadvantage of a secured debt consolidation loan is that it puts your collateral at risk. Suppose, for example, that you put your house up for security. If you fall behind in your payments, you could lose your house. Another disadvantage is that you might be fooled into thinking that your financial situation has greatly approved, tempting you to take on more debt. This can create a spiraling effect which can eventually lead to bankruptcy. Regardless of whether the loan is made on a secured or non-secured basis, it almost always will require a hard-inquiry credit check which may temporarily lower your credit rating. Some loans will include a loan origination fee. If the fee is exorbitant, you could end up owing more money after the consolidation than you did before.
Debt Consolidation Loan vs. Balance Transfer Card
Obtaining a debt consolidation loan is almost like transferring a credit card balance, but it is not the same. Firstly, a debt consolidation loan can be used to pay off any outstanding balance. However, a balance transfer will only take care of credit card balances. In most cases, it cannot be used for other debts, such as a car loan or student loans. One exception to this would be a cash advance. However, cash advances typically carry a much higher interest rate, especially when compared to a debt consolidation loan.
Sometimes there is a transfer fee which reduces the potential benefits. Many cards offer a no-interest or low-interest introductory rate for a fixed amount of time following a balance transfer. However, the interest rate may jump dramatically once the promotional period expires.
Whether a debt consolidation loan or a balance transfer would work best for you depends on several factors. A loan that includes a substantially lower interest rate would allow more of your monthly payments to be applied to the principal, which would make it easier for you to pay off the loan more quickly. However, you should watch out for any charges and transaction fees that could increase the loan balance. Keep in mind that debt consolidation loans and balance transfers typically require hard inquiries to your credit report which can temporarily lower your credit rating.
What to Consider When Choosing a Debt Consolidation Loan Company
In choosing a debt consolidation loan company, the first thing you should look for is integrity. You want to make sure that you are dealing with a reputable company so that you will not become a victim of fraud. If you have any doubts, you can check the company out through one of your state offices, such as the Attorney General’s Office. If you’re a member of a credit union, that would be a good place to start. After that, banks are probably the next best choice, followed by loan companies.
When making your choice, be sure to take into consideration the interest rates, the terms of the loan, repayment options, fees and any penalties that might apply. Ask your lender to show you the total amount of interest that you will be paying over the life of the loan. Also, to be sure that you’re getting the best deal, you may want to apply to multiple lenders.
In order to secure the loan, you will have to meet the requirements of the lender. Once you apply for the loan, the lender most likely will check your credit report and credit score. They also will want detailed information about your other debts, your income, and other factors that might affect your ability to repay the loan.
In some cases, they may even go so far as to check with your present employer concerning the security of your job going into the future. You probably will be asked to submit some documentation such as copies of income tax returns and pay stubs. If you qualify for a loan based on the information submitted, the lender will then propose a new loan and explain the terms.
If you have any questions at that point, don’t be afraid to ask. You should make sure that you understand what is being offered and how it will impact your financial future, should you decide to accept it.