Debt Consolidation Loans: A Definitive Guide

The information provided here about debt consolidation loans is for informational purposes only and is not intended as financial advice.

Of all possible ways to get out of the red and increase your net worth in a shorter period of time, debt consolidation is among the quickest and most effective.

How many times have you been faced with a choice between sticking to your budget and shelling out for your friend’s birthday party or happy hour with coworkers? Expenses add up on top of student loan repayments, and sometimes swiping a credit card feels like the easiest way to solve the problem in the short term. Maybe you’re exhausted by the fact that your income minus expenses does not equal the life you want to be living.

That is where debt consolidation can come in: switch out multiple loan payments with one loan on new terms that work better for your unique financial situation. It can take a matter of minutes or hours and save you thousands of dollars over the course of your debt obligation or allow you to pay off your debt sooner, and save you from the stress of dealing with multiple loans. Let’s explore how.

How debt consolidation works

A debt consolidation loan takes your existing debts and replaces them with one, new loan, making repayment more convenient by bundling multiple payments into a single, predictable one.

Though terms differ, debt consolidation often affords you the opportunity to either decrease your monthly payments or decrease the amount you’ll pay overall. Consult the following decision tree, which outlines these options based on the goal that is right for you:

Debt Consolidation Decision Tree

As you can see, if lower monthly payments work better for your financial situation, you can consolidate with a longer loan term, or a lower interest rate loan. If you would prefer to pay less overall, you can consolidate with a shorter loan term, or one with a lower interest rate.

Debt Consolidation Loans

How do debt consolidation loans ease the pain?

Let’s consider a hypothetical young professional named Chloe. Chloe just started a new marketing job. With a relatively high starting salary,  she was surprised when after a couple of months in the new gig she was getting nervous about when her next paycheck would hit. At this stage of life, with no dependents and few obligations, she shouldn’t be living paycheck to paycheck.

But in addition to her monthly expenses, she had some student loans to pay off and a loan to help cover living expenses from her New York City internship last summer. Chloe has two $10,000 loans: a student loan with a 5% interest rate, and a private personal loan with a 15% interest rate. Both have to be paid off in equal monthly payments over the next five years. To put it simply, Chloe has to pay $425 every month ($188 for the federal loan and $237 for the private personal loan) until her debt is cleared in 5 years:

Debt Consolidation Loan Example

Eager to get out of her rut, Chloe explores debt consolidation.

Chloe shops around and learns that she can roll both of her loans into a single loan with an 8% interest rate. She has a choice: if she chooses to pay her loan back over a 5 year period, she cuts her monthly bill down to $405/month, and will save $1,265 over the 5 years.

If she chooses a loan term of 10 years instead, she decreases her monthly payment all the way down to $242/month, which would be a huge help right away. However, she’ll pay more in the future. She has an additional 5 years of payments to make, and will pay an additional $3,522 over those 10 years in interest.

Debt Consolidation Loan Comparison

Chloe can now make the choice that’s right for her, and with one consolidated loan, she doesn’t have to keep track of all those different payment dates, and can focus on that new job.

Chloe found this all out using a simple online loan calculator. You can do the same thing, testing different options until you find one that works for you.

Debt consolidation loans replace multiple existing loans with a single loan that has new terms, such as a new interest rate or repayment period.

How to take advantage of debt consolidation loans

How To Manage Debt

While debt consolidation loans can give you breathing room, they don’t eliminate the total amount of debt you owe. The idea is to try to make that debt more affordable by getting informed on how a debt consolidation loan can work for your unique financial situation.

You can manage your debt and payments with 5 basic steps:

Step 1: Know your debt

Find the principal balance and the interest rate for each of your debt accounts, including credit cards.

Step 2: Know your goal

Determine the goal of your debt consolidation. Do you want to reduce the total payment term or keep the same term and pay less every month? See our post on setting goals for ideas on how to make this decision, and revisit the decision tree above and think about what would be most helpful to you and your finances.

Step 3: Find your new interest rate and loan terms

There are several companies that will help you consolidate your debt, from banks to online lenders. Many companies will give you an interest rate based on your credit score, but some lenders recognize that your credit score does not define you. For example, Upstart looks at your education, employment and several other factors in an attempt to offer you the best rates possible, even if you don’t have a lot of credit history.

#protip: Protect your credit score while comparing options. Some lenders may do a hard credit check during the application, which can negatively  impact your credit score.

Step 4: Choose the best option for you

Once you have found the debt consolidation loan that works for you and your goals, it is time to decide. Check for fees, interest rate changes, and prepayment penalties.

Double check to ensure that your decision leads to the best outcome using this loan calculator.

Step 5: Pay it off

Once you receive your debt consolidation loan, a lump sum will be deposited into your bank account. It is up to you to pay off each of your previous debt accounts.

Now set a payment date for your new debt consolidation loan. Enroll in automatic debit to set it and forget it.

You’re on your way to financial freedom. Enjoy!

 

Financial Freedom

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