What Is Debt Consolidation?
Debt consolidation simply is the financial acting of taking new loan(s) to pay off other liabilities and consumer debts. Using this instrument, multiple debts are combined into a single, larger debt, such as a loan, usually with more favorable payoff terms, say a lower interest rate, lower monthly payment, or a combination of both. Essentially, two types of debt consolidation loans: secured and unsecured.
Debt consolidation is a process where multiple debts, often from things like credit cards, are rolled into a single payment.
Debt consolidation can substantially decrease the interest rate value you have to pay altogether on multiple loans. By consolidating your loans into a single loan you are able to pay off debts faster and cheaper. Through consolidation, you only need to manage one loan, instead of multiple monthly payment bills with their own administration fees.
What Is a Secured Loan?
Secured loans are debt products that are protected by collateral. This means that when you apply for a secured loan, the lender will want to know which of your assets you plan to use to back the loan. The lender will then place a lien on that asset until the loan is repaid in full.
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When you take out a secured loan, such as a mortgage or a car loan, you pledge specific property, such as your home or your car, to secure the repayment of the debt. You have many options for consolidating your debt using a secured loan. You can refinance your house, take out a second mortgage, or get a home equity line of credit. You can also take out a car loan, using your automobile as collateral. Or you can also use other assets as security for a loan.
A variety of financing firms will also loan you money against lawsuit claims, lottery winnings, and annuities.
What Is an Unsecured Loan?
An unsecured loan is a loan that doesn’t require any type of collateral. Instead of relying on a borrower’s assets as security, lenders approve unsecured loans based on a borrower’s creditworthiness. In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment
Unsecured loans are based only on your promise to pay and aren’t secured by any property that can be foreclosed or repossessed to repay the debt. Credit cards are examples of unsecured loans. Unsecured loans usually have a higher interest rate because they carry more risk for the lender.
Online lenders, banks, and credit unions offer unsecured personal loans that you can use to consolidate credit card debt and other kinds of debt. Also, some people use a no interest, or low interest, introductory rate on a credit card as a substitute for an unsecured personal loan for debt consolidation.
How does debt consolidation work?
There are several ways to consolidate debt, but the general process is paying off current debts using new debt. This can be done by taking out a personal loan or home equity loan, by transferring your balance to a new credit card or by working with a credit counseling agency to establish a debt management plan.
In these situations, you use the new funds to pay off your current debt. You are then left with one payment on the new loan on balance transfer card instead of needing to keep track of multiple payments. Debt consolidation can also save money if you can find a loan with lower interest rates and fees than you had with your previous debts.
A debt consolidation loan is one of the most common and easiest ways to consolidate debt. You apply to borrow the amount that you owe on your existing debts. Once approved for the loan, you receive the funds and use them to pay off your credit cards or other loans. In some cases, the funds can be sent directly to your creditors.
From there, you begin making monthly payments on your new debt consolidation loan. These loans are unsecured, which means you do not need to put up collateral. Personal loans also come with fixed interest rates and monthly payments.
How do I qualify for a debt consolidation loan?
Lending criteria differ by each lending institution for qualifying borrowers, but the most Common requirements are that borrowers be at least 18 years old, legal residents of their current nation of residence, and not in foreclosure or bankruptcy. Most lenders look for a minimum credit score in the mid-600s and a debt-to-income (DTI) ratio below 45 percent.
An excellent credit score and low DTI will get you the best interest rate and may qualify you for a larger loan. Even if you have bad credit, you may find a lender that’s willing to extend you a loan, but you all pay higher interest rates. If you are in this scenario, you may want to apply with a co-signer who has good credit to improve your chances of being approved.
Steps to get a debt consolidation loan
i. Determine how much you need to borrow.
Before you choose a lender, calculate your existing debt to determine the amount you will need to borrow.
ii. Check your credit score.
To qualify for a debt consolidation loan, you typically need a credit score of 600 or higher. Your credit score also impacts the rate you receive.
iii. Get prequalified.
Many lenders allow you to prequalify online without committing to anything or hurting your credit score.
iv. Compare rates and loan terms.
Before choosing a lender, carefully consider the terms of each lender. Choose the one that has the best rates and terms for your situation.
v. Choose a lender and apply.
Once you have decided on a lender, prepare the necessary documents and apply. Many lenders let you apply online, but you can also apply in person at a financial institution.
Factors to consider before choosing debt consolidation loan lender
It is very important to get a debt consolidation loan that fits your budget and helps you reach your goal of eliminating debt. Many lenders will prequalify you without making a hard inquiry into your credit. Prequalification gives you a good idea of the rate, loan amount and loan term that you could qualify for.
Here are the factors to consider before choosing debt consolidation loan lender:
- Annual percentage rates: Your APR is determined by your credit score and other financial factors. This is the amount charged on top of your principal amount every month.
- Loan cost: When you shop, compare the total cost of each loan, including origination fees and other charges. A large number of fees can outweigh the benefits of a low APR.
- Lender features: Potentially helpful features to search for are things like the new lender making direct payments to your previous creditors, credit monitoring, hardship programs and other customer service programs.
Alternatives to Debt consolidation.
- Create a budget that permits you to keep up on your debt obligations.
- Make arrangements with creditors to arrange a solution, like a reduced interest rate, a lower minimum payment, or the removal of late penalties or other fees
- Settle your debts for less than you owe on your own or with the help of a legitimate credit counseling agency or lawyer (avoid debt settlement companies, though),
- Enter into a legitimate debt management plan, or declaring bankruptcy.
Will a debt consolidation loan hurt my credit score?
Yes. Applying for a debt consolidation loan may temporarily lower your credit score, because lenders usually do hard enquiries before approval. However, if you make your monthly loan payments on time and not accumulate card balances again, a credit card consolidation loan can improve your credit score.
What are the risks of a debt consolidation loan?
Chief amongst the risks associated with debt consolidation loan is its potential to get you deeper into indebtedness. Except you have a stringent control on your finances, your debt consolidation might be of little or no effect.
Because you are paying off several debts with the loan, your monthly payments can be steep; it’s not like making minimum monthly payments on several credit cards. You have to be sure you can handle the payments until the loan is repaid.
How long does it take to get approved for a consolidation loan?
For debt consolidation application, approval turnaround times typically vary per institution. For instance, online lenders may approve your loan within a few minutes, while banks may take a few days or up to a week to process. However, once your loan is approved, funding can arrive within 24 to 48 hours or up to one week, depending on your lender.
Summary
While debt consolidation loans are very useful tools for reducing or clearing your debt, it must be approach with utmost caution to avoid plunging yourself deeper into debt.