How Debt Consolidation Loans Work

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If you’re in debt – even if you manage to pay your bills every month – it may seem like you’re not doing well at what you owe. That’s when debt consolidation can help.

Debt Consolidation this is when you combine several debts into one loan that has one monthly payment and one (hopefully lower) interest rate. This will help you stay organized and possibly save money.

What is a debt consolidation loan?

BUT debt consolidation loan this is one way to refinance your debt. You will apply for a loan for the amount you owe on existing debts, and once approved, you will use the funds to pay off your balances. You will then repay the new loan over time.

When choosing a loan for debt consolidation, you will need to evaluate several different characteristics:

  • Loan type: The most common types of loans include personal loans, credit cards with an initial 0% per annum, 401 (k) loans and loans secured by real estate
  • Loan conditions: The loan amount, interest rate and loan duration depend on the type of loan you receive and your financial condition.
  • Protected and unsecured: With a secured loan, you must defer the collateral. For example, your home is secured by a home equity loan. If you are late in payments, the lender can take this collateral to pay off your outstanding balance. If you don’t want to risk your assets, consider sticking to your unsecured options such as personal loans and credit cards with a zero annual interest rate.

How does a debt consolidation loan work?

Most debt consolidation loans are fixed rate installment loans, which means the interest rate never changes and you make one predictable payment every month. Thus, if you have three credit cards with different interest rates and minimum payments, you can use a debt consolidation loan to pay off those credit cards, leaving you with only one monthly payment instead of three.

Let’s say you are paying off a credit card debt. Here’s how a debt consolidation loan can help you save on interest costs:

  • Card 1 has a balance of $ 5,000 with an annual interest rate of 20 percent.
  • Card 2 has a balance of $ 2,000 with an annual interest rate of 25 percent.
  • Card 3 has a balance of $ 1,000 with an annual interest rate of 16 percent.

If you pay off your credit card balance within 12 months, your interest expense is $ 927. But suppose you take out a 12 month personal loan for the amount you owe – $ 8,000 – at 10% per annum. If you repay the loan within one year, you will lower your interest rate to $ 440. To calculate your savings on your own debt, try using credit card payout calculator and personal loan calculator

Benefits of a debt consolidation loan

If you want to save money, simplify your monthly payments, and circle the due date on your calendar, then debt consolidation might be the right fit for you. Here are the main benefits:

  • Pay off your debts faster. Making the minimum credit card payment can stretch the maturity period for years. A debt consolidation loan can speed up the repayment process.
  • Save on interest costs. Generally, if you are eligible for a lower rate than the one you are paying now, you will save money on interest payments. As of the end of October 2020. average interest rate on a credit card was 16.02 percent, while average rate on an individual loan amounted to 11.88 percent.
  • Simplify your monthly payments. Managing one monthly payment is easier than managing multiple payments with different due dates. This lowers your chances of missing payments, which is good for your credit.
  • Pay on a fixed schedule. Many debt consolidation loans are fixed installment loans, which means you know exactly when you will be out of debt. This can help motivate you to pay off your debt.

Debt Consolidation Loan Risks

Before moving forward, you will need to weigh your immediate needs against long-term goals. Some people choose to consolidate debt to save money and organize their monthly payments, but there are downsides to consider.

  • This will not solve all of your financial problems. Once you use a debt consolidation loan to pay off your debt, you may be tempted to start using credit cards again. This increases your overall debt, which can affect your credit and make it difficult to pay off balances.
  • There may be some upfront payments. Some debt consolidation loans include fees including loan originating fees, balance transfer fees, prepayment penalties, annual fees and more. Before taking out a loan, ask the lender if any of these requirements apply.
  • You can pay more in interest. This could have happened in two ways. Depending on your credit rating, debt-to-income ratio, and loan amount, you may be paying a higher interest rate than on the original debt. Or, if you use a debt consolidation loan to lower your monthly payments by increasing the maturity, you may end up paying more interest in the long run.

Understanding interest rates on debt consolidation loans

When you pay off a debt consolidation loan, you are not only paying back the amount you borrowed – you are also paying an additional amount monthly in the form of interest. Interest rates on debt consolidation loans usually range from 5.99 percent to 35.99 percent. A higher interest rate will cost you more over the life of the loan than a lower interest rate. Each lender has different criteria for setting rates, so shopping around can help you find the best deal.

Typically, lenders check these factors when deciding if you qualify and set your interest rate:

  • Your credit rating: Borrowers generally need a credit rating of mid 600 to qualify for a debt consolidation loan, and a higher score can help you get a lower interest rate.
  • Your DTI: Your Debt To Income Ratio (DTI) tells lenders how much of your monthly income goes towards paying off your debt. Lenders tend to look for a lower DTI.
  • Income: The lender will review your work and check if you are earning enough to make payments.

If you do not quite meet your credit requirements, you can find a lender who is willing to provide you with a loanalthough you can get a higher interest rate. If you are in such a situation, consider adding a collaborator to your loan. This person promises to take over the payments if you fall behind, so he needs to understand what is wrong before saying yes.

How to Apply for a Debt Consolidation Loan

It takes a little work, but it pays off if the debt consolidation loan saves you money. Start by getting a loan, comparing quotes from several lenders, and checking your chances of getting a loan approved.

  • Understand your finances. A good credit rating gives you a better chance of getting a debt consolidation loan and getting a good interest rate. Check your credit score before applying to see if he needs a job
  • Compare the terms of the lender. Finding the best deal will help you save money on debt consolidation. Get quotes from multiple lenders and compare interest rate, commission, loan term and monthly payment.
  • Pre-qualify. Some lenders offer pre-qualification, which gives you an idea of ​​what kind of offers you can get. Many of them can only perform a soft credit charge, which means that prequalification will not affect your credit rating.
  • Collect what you need to apply. When applying for a debt consolidation loan, you may need your social security number and contact information, an estimate of your monthly debt obligations, and a pay slip and employer information to prove income.

Once you get approved, the lender can repay your loan funds to your lenders or send the funds to you. Make sure the original debt is paid off and then start working on a new loan. Set up automatic payments or use reminders to make payments on time every month. Over time, you will be free from debt.

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