Loan consolidation simply means combining several debts into one. Loan consolidation is another name for debt consolidation. It can help you organize your payments, reduce your monthly expenses and lower the interest rate you pay.
Alternatives to loan consolidation
It is also very important to choose the right consolidation loan with an affordable payment.
If you do those things, loan consolidation could leave you with a debt load that is much easier to manage. This article will help you understand what you need to know to make the right decisions about loan consolidation.
Even if you are current on your debt payments, loan consolidation can save you money if your interest rates are high and you have month-to-month balances.
Why consolidate loans?
The combination of multiple debts into one does not "eliminate" your debt, it simply changes it. So, loan consolidation is just the problem?
Not with a good consolidation product and strategy. Here are some of the things that loan consolidation can do:
Simplify your debt payments. Even if you have automated bill payments set up, having different amounts coming out of your bank account at various times can lead to confusion. Reducing everything to one monthly payment makes it easier to keep track of your money.
Reduce your monthly payments. This can be accomplished in several ways. Loan consolidation can reduce your monthly costs by extending your repayment period, reducing your interest rate, or both.
Reduce your interest cost. This is often the biggest benefit of loan consolidation. Replacing high-interest debt with a lower-interest debt consolidation loan can reduce both monthly payments and interest charges.
Improve your credit score. From reducing your credit utilization rate to helping you keep your payments current, debt consolidation could boost your credit score.
Accelerate your payment. If your interest rate is lower, more of your payment goes toward reducing your balance. So, if you continue to pay the same amount, your debt will go down faster. And if you choose a consolidation loan with a shorter term, you'll be forced to pay off your debt sooner. Just make sure the payment is affordable.
You may not achieve all of the above goals with your loan consolidation program. However, if you can achieve one or more of them, you may find it worthwhile.
How does loan consolidation work?
Certainly, the benefits of loan consolidation can sound tempting. So how does it work?
The simple answer is to take out a new loan and use the proceeds to pay off other debts. However, you must get the details right to make sure this works in your favor.
Your first task is to decide why you want to consolidate: do you want to pay less interest, reduce your payments, accelerate debt repayment, or replace variable rate bills with a fixed rate loan?
You can manage the size of your monthly payment by lengthening or shortening the repayment period of your consolidation loan. Just keep in mind that while a longer repayment period may provide you with lower monthly payments, it may increase your total interest expense over the long term.
The best form of loan consolidation offers you a lower interest rate. If the consolidation loan has a higher rate, it only makes sense if you are trying to replace variable rate loans with a fixed rate, or because you need to spread out the payment to make it affordable, and a lower rate is not available.
You will also want to decide which debts to include in the loan consolidation. If you are trying to reduce your interest, you will only consolidate accounts with higher rates. Mortgage debt is usually a poor candidate for loan consolidation. Mortgage rates are generally relatively low and repayment terms are often quite long.
The following sections of this article will discuss some types of debt you might consider for loan consolidation. After that, there will be a discussion on how to find the right loan to consolidate these debts.
Consolidation of student loans
Student debt comes in a variety of forms. The most common are government-sponsored student loans. However, there are also some private student loans. In addition, students sometimes have to use credit card debt to finance some of their student expenses.
You should think very carefully before refinancing government-sponsored student loans. They offer a variety of repayment programs and borrower protections that private loans do not. In addition, government-sponsored student loans generally have fairly low interest rates.
Private student loans do not usually offer the same types of special advantages for borrowers. Therefore, private student loans may be good candidates if you can find a new loan with a lower interest rate.
If you used a credit card to cover student expenses, you may be an excellent candidate for loan consolidation. The next section discusses more about why credit card debt should be a prime target for debt consolidation.
Credit card loan consolidation
According to the Federal Reserve, during the first quarter of 2022, the average credit card interest rate exceeded 16%. At the same time, student, personal, auto and mortgage loan rates were below 10%.
In other words, credit card debt is especially expensive. When looking to reduce debt, it makes sense to prioritize getting rid of your most expensive debt first.
This makes credit card debt an excellent candidate for debt consolidation. Its high interest rates mean that getting rid of it will do the most good, and it should be relatively easy to find a consolidation loan with a lower rate.
Make sure your credit card debt consolidation doesn't just erase your balances so you can start racking up new charges again. Consolidation works best when it is part of a larger program to live within your means.
Consolidation of personal loans
It may be a good idea to consolidate any outstanding personal loan balances, depending on the circumstances.
Two main conditions that determine whether personal loan consolidation makes sense are:
If you can find a lower interest rate alternative to replace your current personal loan debt
If there are no prepayment penalties on your existing debt that would negate the benefits of replacing the debt
You can also use loan consolidation to help organize your personal loans and change your repayment period. However, reducing your interest rate is the best way to save money.
Types of debt consolidation loans
There are several types of consolidation loans. The right one for you depends on your objective, loan amount and financial resources.
If you have equity in your home, a cash-out refinance mortgage may be a good option. These often have relatively low interest rates. Just make sure you are confident in your repayment plan before putting your home up as collateral for a loan. Understand that cash-out refinancing comes with fees that apply to the entire loan, not just the cash-out. That can make it very expensive.
Home equity loan or line of credit (HELOC). Home equity loans have lower closing costs and can be completed faster than cash-out refinancing, although interest rates are higher. They are good for larger loan amounts. The HELOC have lower set-up costs: a few hundred dollars or even zero. However, their interest rates are variable, so you may want to use one for smaller amounts. Home equity financing has a long repayment period, so it's great for keeping payments low.
If you have reasonably good credit, a personal loan could work for loan consolidation. And applicants with excellent credit can find rates that rival home equity rates. You should be able to get a personal loan with a much lower interest rate than most credit card debt. Personal loans have fewer moving parts and fees than many home equity loans.