How Debt Consolidation Loans Work

How They Can Help, How to Qualify and a Word Of caution

The idea behind debt consolidation is simple. You roll all of your high-interest debt such as credit cards, payday loans and other debt into a single payment with a lower interest rate.

There are two ways to consolidate your debt into a single payment.

1. Pay off all your debts with a Home Equity Line of Credit (HELOC)
2. Apply for an unsecured consolidation loan

The HELOC method is only available to homeowners who have enough equity in their homes to qualify. This involves taking out a “secured” line of credit against the equity you have in your home. The term “secured” means the bank is using your house as collateral for the line of credit.

You then use the funds available in that line of credit to pay off all of your other debts and consolidate your debt into one, lower monthly payment.

Using a HELOC is a double-edged sword.

• On the one hand, it is likely the lowest interest rate you will find.
• On the other hand, you could lose your house if you don’t make your payments.

If you don’t own your home or don’t have enough equity to qualify for a HELOC you can apply for an “unsecured” consolidation loan. Since the loan is “unsecured” against other assets you have like your home, the interest rate will likely be higher than a “secured” loan like a HELOC. Since the bank is taking more risk with an unsecured loan, they price that higher risk into the loan through a higher interest rate.

If you are approved for a consolidation loan the process is the same, all of your debts are paid off and consolidated into a single monthly payment.

When it makes sense to consolidate your debt

If you have a large amount of high-interest debt, spread throughout several different loans it might make sense to consolidate your debt.

Let’s say you have $25,000 in credit card debt spread throughout three different cards.

• Card 1 has a $5,000 balance at an 18.9% interest rate and a minimum payment of $130.
• Card 2 has a $10,000 balance at 15% interest rate and a minimum payment of $338.
• Card 3 has a $10,000 balance at a 20% interest rate and a minimum payment of $267.

That totals to $25,000 in debt at an average interest rate of 18% with total minimum monthly payments of $735. At that rate, it would take you more than 36 years to pay off all three credit cards. During that time, you would pay nearly $40,000 in interest.

If you were able to consolidate all three credit cards onto a single consolidation loan with a 5-year term and an interest rate of 10%, your monthly payment would be $531. You would be debt-free in five years and pay $6,900 in interest.

A debt consolidation loan makes a huge difference in that type of situation.

How to qualify for a debt consolidation loan

To get approved for an unsecured debt consolidation loan the bank will look at many factors including but not limited to.

• Your credit score. Since the bank does not have an asset to secure against the loan, they will look closely at your credit score and credit history to determine how likely you are to pay them back.
• Your income. The bank will want to verify that you earn enough money to make the payments. They may also be interested in how long you have been with your employer as this speaks to your level of job security.
• Your debt to income ratio is calculated by dividing your debt payments by your monthly gross income. This is another way for the bank to determine your ability to manage the loan. The higher your debt to income ratio, the lower your chance is of being approved for the loan.

These are not the only factors the bank will use to assess your application, but they are major factors you should be aware of before applying for a debt consolidation loan.

A word of caution

A debt consolidation loan can be a great way to lower your monthly payments, pay less money in interest and get out of debt sooner. However, a debt consolidation loan is not going to fix the underlying problem; how you manage your money.

• Do you know what is worse than having $25,000 in credit card debt?
• Consolidating your debt into a $25,000 consolidation loan only to rack up another $25,000 in credit card debt because you never learned how to manage your spending.

Managing your spendings and staying out of credit card debt is simple but requires a daily commitment. Start by tracking your expenses to see where your money is going and then create a budget that ensures you are spending less than you are making.

A consolidation loan is a useful tool, but it is by no means a magic wand that will make all your financial problems disappear.

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This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions