When you’re stuck with high-interest loans or massive credit card balances, it’s hard to envision a future where you aren’t overwhelmed by debt. If that describes you, you may be considering a debt consolidation loan to help dig yourself out.
Personal loans for debt consolidation are offered by many banks and credit unions. They allow you to combine your existing debts into a single loan with one fixed monthly payment.
However, debt consolidation loans are only suitable in certain scenarios. Here’s what you need to know to determine if a debt consolidation loan is right for you.
How Debt Consolidation Loans Work
Debt consolidation loans roll all your existing debts into one loan with a single monthly payment. If you are approved for a loan, the financial institution will issue the funds needed to pay off your creditors. You will then be responsible for paying back the lender.
You will have a fixed monthly payment for a set time (for example, $150 a month for 60 months), although you can pay extra each month to pay off your loan faster. Once your balance is paid off, you’re free and clear.
When is Debt Consolidation a Bad Idea?
Debt consolidation isn’t always the best way to get out of financial trouble. You’re simply shifting your debts from one place to another, so it isn’t worth doing if the loan doesn’t improve your financial situation.
Depending on factors including your credit score, you may not be able to qualify for a personal loan with a lower interest rate. Unless you’re in desperate need of a lower payment, you should never take out a loan with a higher interest rate than your current debts, you should not take out the loan. You’ll end up paying more in interest than you currently do!
You also need to look at the lifetime cost of a debt consolidation loan. Even if the loan has a lower interest rate and lower monthly payment, it might be more costly in the long run. If the length of the loan is much longer (say, 60 months) than it would take you to pay off your existing debts, you could end up paying more over time!
In short, debt consolidation is a bad idea if you can’t get a lower interest rate of if you end up paying more over the lifetime of the loan.
When is Debt Consolidation a Good Idea?
Debt consolidation is a good idea if you’re in desperate need of relief and you can’t negotiate lower interest rates with your credit card companies or creditors. If a lower payment would keep you from losing your home or your car, for instance, it might be worth it to take a debt consolidation loan.
It’s also a good idea if you can get a lower interest rate than you’re paying now and the lifetime cost of the loan is lower than your existing debts. A single monthly payment with a lower interest rate means you could end up paying less to eliminate your debt, so long as it won’t take you much more time to pay it off.
In short, debt consolidation is a good idea if you can save money on interest and the lifetime cost of your loan, or if you are in desperate need of a lower payment and you can’t work out another solution with your creditors.
Whether or not a debt consolidation loan works for you really depends on the numbers. Before you open a debt consolidation loan, you should compare the numbers to your existing debts to see if you would actually save money. If, in the long run, the debt consolidation loan is cheaper, it is a viable option.
One thing to consider is your ability to responsibly manage credit cards. If you rack up more credit card debt after using a loan to pay down your balances, you will be in even worse shape than before!