A debt consolidation loan is a loan that takes many individual debts and combines them into one. Basically the consolidation loan amount is based upon the amount of debt you have. For example, if you have five credit cards with a total debt balance of $15,000.00, your consolidation loan (excluding fees, which will be discussed below) would be $15,000.00.
You may be wondering why one loan for $15,000.00 would be more beneficial than five loans totaling $15,000.00. The answer is, a consolidation loan should provide a lower interest rate and will bring consistency, predictability, and organization to your debt situation. For example, if you have five credit cards and each had a different interest rate, you may pay more in interest by keeping the debt separate. If your five credit cards have interest rates of 10%, 15%, 18%, 20%, and 25%, for example, your average interest rate would be 17.6%. A consolidation loan may give you an interest rate of 12%. Therefore, your interest rate would be 5.6% lower than the average of your five credit cards.
It is important to note that the balance on each credit card matters. For example, if you owe $14,996.00 on the 10% interest rate credit card and $1 each on the 15%, 18%, 20%, and 25% interest rate credit cards, consolidating at 12% would not make financial sense as the vast bulk of your debt has only a 10% interest rate. If however, like most people, you have about the same balance on every credit card, a consolidation loan may help save you money on interest.
Watch Out For Fees:
Many consolidation loans have fees attached. For example, the lending institution may charge you a $1,000.00 fee for consolidating your $15,000.00 in debt. At this point, you need to do some math. In our example, you need to calculate whether you would save more than $1,000.00 in interest payments over the course of the consolidation loan. This is essential because the fee charged for the consolidation must be less than the interest saved. If the fee is more than the savings you will receive, it does not make sense to take the consolidation loan.
Make Sure You Know All of the Terms:
Make sure that you know the plan for repaying the consolidation loan. Your one monthly payment on the consolidation will most likely be less than the total amount of the payments on your five credit cards. However, make sure this difference is not due a specialized repayment schedule. For example, the consolidation loan company may show you that your monthly payments will be lower than the total of your combined payments, but only if you make “interest-only” payments. The bottom line is, if the principal and interest payments on the consolidation loan are not lower than the principal and interest payments on the five credit cards, do not take the consolidation loan.
Consistency, Predictability, and Organization:
The greatest advantage of a consolidation loan is that you have to make only one payment each month, and you will know exactly how much you have to pay. Unlike credit cards, a consolidation loan is generally an installment loan. This means that you cannot increase the amount of the loan. Common examples of installment loans are car loans, student loans, and home mortgage loans. Credit cards are revolving loans and thus, you can use the credit line to purchase goods and services. Such is not the case with installment loans.
Because of this fact, you will have consistency and predictability in your loan obligations. Additionally, you will be able to better organize your finances.
Consolidation loans can lower the interest rates on your outstanding debt. Make sure the consolidation loan interest rate is less than the averaged interest rate of all of the debt you seek to consolidate. Watch out for fees and make sure that the money saved on interest payments is greater than any fee the consolidation loan company charges. Make sure you know all of the terms of your consolidation loan. Should you decide to obtain a consolidation loan, look forward to the consistency and predictability.