Debt Consolidation Loans

debt consolidation loan guide chapter 3

Read the fine print before you apply.

A traditional debt consolidation loan is pretty simple. A bank, mortgage company, credit union or finance company grants you a new loan and you use the proceeds of the loan to pay off your current debts and “consolidate” them into one new, larger loan.

By doing so, you swap several debt payments each month with one single payment on your new loan.

With a debt consolidation loan, you eventually will pay off all of your debt, plus interest. However, because you can generally negotiate a lower interest rate than you were paying before, you can actually get out of debt sooner.

Not all debt can be consolidated. Credit card debt, utility bills, car loans and other personal loans can, but mortgages and tax debts cannot. You’ll need fairly decent credit to qualify for a debt consolidation loan, and you’ll have to make enough money to repay the loan.

You might also need someone to co-sign your loan, and the bank might require collateral, such as your car or house. You probably will be able to obtain a better interest rate and extend your payments over a longer time period if you use the equity in your home to refinance with a second mortgage.

Know What Your Total Costs Will Be

Loans come with different interest rates, fees, payment schedules and flexibility. You should consider all of these factors before choosing the product that fits your situation the best.

Interest and Fees

The exact rate you will pay on a debt consolidation loan will depend on many factors, including your credit score, your debt level relative to your income and assets and whether or not you are willing to offer collateral for your loan. Banks and credit unions tend to offer the lowest rates. Finance companies tend to charge a higher rate because they are often loaning to individuals who have been turned down by a traditional lender. Lenders who specialize in low-credit or no-credit loans are, of course, the most expensive option.

In addition to the actual interest rate, you also need to carefully understand all possible fees and charges. Your interest rate might seem reasonable, but life insurance or disability insurance fees and other seemingly unnecessary service charges or penalties might run up the cost of your loan. Make sure you understand the costs for missed or late payments and ask if there are any up-front application fees.

The Length of Your Loan

How long are you going to take to pay off your loan? It’s certainly true that $200 a month looks a whole lot more affordable than $250 a month. However, that $50 a month savings means you might be paying off the loan for six or seven years instead of five, which means paying interest for one or two more years.

warning termOur advice: You should choose the shortest term that you can afford. If your payment still looks like more than you can afford, you should consider other options, such as a debt management plan or a consumer proposal.

Flexibility

You decided to consolidate your debts because you were having trouble keeping up with your monthly payments. In looking at your new loan, be sure to consider the following:

  • If you are taking out a second mortgage, are you permitted to prepay or make additional payments without penalties?
  • Can you skip a payment if you hit a temporary financial bump in the road; and if you do, will you have to pay a penalty or add to the long-term cost of the loan by rolling that month’s interest into your mortgage?
  • Beware of interest-only loans. While your monthly payment might be lower than with other options, you may be paying off the debt for the rest of your life.
  • Be wary of variable rate loans. They may look attractive today, but you might be in serious trouble later when the interest rate increases.

The Bottom Line

Your monthly payments should be as high as you can afford without taking on too much risk. The best way to figure out which loan works best for you is to look at the total amount you will have to pay over the life of the loan, including interest and fees. If you can afford the monthly payments, you should choose the loan with the lowest total payback amount.

Read the fine print, ask questions and learn as much as you can about debt consolidation loans before you apply for one.

Should You Use Your Home Equity?

Depending on your credit history and which assets you have to offer as collateral, you can choose to consolidate your debts with either a secured or an unsecured loan.

The most common form of unsecured debt is the money you owe on your credit card. You can opt to consolidate several credit cards into one, combine them into one unsecured line of credit, or you may qualify for an unsecured bank loan.

With a secured debt, you would be offering an asset as collateral like your home. A second mortgage or home equity loan are the most common types of secured debt consolidation loans.

Financially speaking, if you are certain you can repay the debt, a secured loan can work out better for you. You generally can get a lower interest rate on a secured debt. You’ll certainly be able to repay the loan quicker and with lower payments if you convert 19% interest on a credit card to, for example, 6% interest on a second mortgage on your home.

warning secured loanA word of caution: Using your home or car as collateral can be risky. If you are unable to keep up with your new loan payments, you run the risk of losing your house or car. Once you default on payments, your lender probably will take action to claim the asset you pledged as collateral.

Qualifying for a Debt Consolidation Loan

Three basic factors will determine whether you will be able to obtain a debt consolidation loan: your credit rating, how much money you take in and collateral you might be able to provide.

To assess your application, the bank will want some information about you including:

  • Your monthly budget;
  • Your latest tax returns and pay stubs that show how much money you are earning each month;
  • Your latest loan statements, indicating exactly how much money you owe;
  • Your most recent credit report and possibly other information about your credit history.

Provide some proof.

The bank or credit union that is considering loaning you money will want proof that you are capable of paying the money back. Your lender will want to be able to determine your monthly debt-to-income ratio – the percentage of your salary you use to pay your mortgage costs or rent, plus your other monthly expenses. A normal ratio is in the 36% range. To make this calculation, your banker will need proof of your income, past tax returns and possibly a detailed budget that shows your income and expenses.

Turned Down? Find Out Why.

Don’t pout, walk out, slam the door and vow never to return to your bank if you don’t get the loan. Find out why you came up short. Maybe you can come back in six months or so and try again if you can find a way to reduce your debt or bolster your credit rating.

Limit Your Applications.

It’s not a good idea to apply for a debt consolidation loan at every financial institution in town, especially if you’ve already been rejected a few times. Your credit rating could suffer if several denied applications show up on your credit report.

RUNNING THE NUMBERS

Let’s look at a case study.

John owes $20,000 in credit card debt, and he is managing to pay $500 each month, but would like to know if consolidating his debts through a bank loan is a good choice. John’s debts today are shown in the table below:

consolidating credit card debts

Let’s assume John can qualify for a $20,000 debt consolidation loan from his bank at 10%interest for five years. Here’s how John’s payments would compare:

best consolidation option

Now let’s look at how that option stacks up against John’s possible debt consolidation goals:

debt goals

As you can see, in this scenario, John has achieved all of the debt consolidation goals we outlined earlier. That would make a debt consolidation loan in this case a great option.

But what if John was only making the minimum payments each month? If that were the case, John’s new consolidated monthly payments would increase from $403 today to $425 after consolidation. So why would he consolidate? Because the ability to pay off his debts within five years would significantly outweigh any small increase in his monthly payment.

warning minimum paymentsIf you are making only the minimum payments on your credit card debt, you will not get out of debt in your lifetime.

Summarizing the Pros and Cons

Debt Consolidation Loans – The Advantages:

  • You make only one payment each month.
  • You will be paying less in interest to a financial institution than you were to a credit card company.
  • You might be able to shop around for the best possible interest rate.
  • If you make your payments on time, your credit rating probably won’t be negatively affected and might even improve.

Debt Consolidation Loans – The Disadvantages:

  • Financial institutions might be less flexible than credit card companies in terms of your monthly payments.
  • Your financial institution may require you to close your accounts with stores and credit card companies to make sure you don’t increase your debts while you’re paying off your debt consolidation loan.
  • You might have to provide collateral, which means that if you don’t make your payment promptly, you stand to lose your home or car.
  • Your lender may ask for a co-signer, someone who will guarantee to repay the loan if you are unable to.
  • If you don’t have good credit or collateral, you may not qualify for a low-cost loan.

Should You Take Out A Debt Consolidation Loan?

When looking at the numbers for any debt consolidation loan, consider how the loan will meet your debt consolidation goals.

Did you save money by lowering your interest rate?

Are your payments now easier to manage – both in terms of how many you have to make and whether or not you can afford them?

Does it take care of all of your debts and allow you to pay them off in a reasonable period of time?

Do the collection calls and other creditor actions stop?

If the answer is no to any of these questions, or if your credit rating is not good enough to qualify for a debt consolidation loan, your next option is to consider a debt management plan. We take a look at these plans in Chapter 4.

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