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Debt consolidation loan

Debt Consolidation Loan

What is a debt consolidation loan?

Debt consolidation is the process of taking out a new loan, the proceeds of which are used to pay off other higher-interest debts.

A debt consolidation loan generally allows you to:

  • Enjoy lower interest rates when compared with high-interest rates for credit cards and some other types of loans.
  • Have a lower required monthly payment both as a result of having a lower interest rate and (sometimes) by spreading those payments out over a longer period.
  • Not have the hassle of making multiple payments on different loans each month, with the increased risk of forgetting to make or being late making a payment, hurting your credit score.

Types Of Debt Consolidation Loans

There are several different types of debt consolidation loans, each with different loan requirements, advantages and disadvantages.

Personal Debt Consolidation Loans

Personal loans can be a good option for those with a limited amount of debt that needs to be consolidated. Because these loans are unsecured (meaning there’s nothing that the lender can take possession of and sell if you stop making payments on your loan) they are usually at a higher rate of interest, require a higher credit score, and won’t be as large as one that relies on the equity you have built up on your home.

These loans can usually be obtained through your bank or credit union.

Cash-Out Refinance

A cash-out refinance mortgage loan enables you to take some of the equity you have built up in your home and use it to pay down higher-interest loans. This is usually the least expensive option to consolidate debt if you qualify for this type of loan.

Cash-out refinance loans can be very advantageous because:

  • The interest rate will usually be substantially lower than credit card or other installment debt and lower than a personal debt consolidation loan.
  • Have substantially lower monthly payments both because of the lower interest rate and the fact that those payments are spread out across the entire period of the mortgage.
  • Are “rolled into” your mortgage payments so you don’t have multiple payments to make each month.
  • Can usually be “locked-in” at a fixed interest rate over time, a huge advantage in times of rising interest rates.

Cash-out refinancing loans do require you to refinance your mortgage, so you will have to pay mortgage closing costs (typically 2% to 6% of your loan amount), take a month and a half to two months to close, and usually require you to have a minimum 20% equity after the loan.

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HELOC (Home Equity Line Of Credit)

A home equity line of credit (HELOC) is an open-ended loan that authorizes you to borrow up to a certain amount based on the amount of equity you have in your home. But unlike other loans, where you immediately receive the amount of money you have been approved to borrow, they are a line of credit, meaning that you have the approval to borrow an amount up to the approved amount, anytime you need it.

Many people choose to apply for a HELOC as an option to add flexibility and access to funds just in case – they can draw upon it when cash is needed, pay it back, and draw upon it again later on if another circumstance requires.

In the case of debt consolidation, a Home Equity Line Of Credit can be used to pay off higher-interest loans at a significantly lower interest rate, then pay off the HELOC as quickly as possible, giving you future access to those funds if another situation arises that requires them.

Home Equity Line of Credit loans usually have a higher interest rate than a Cash-Out Refinance mortgage loan and oftentimes have variable interest rates based on the prime rate (meaning they can go up and down depending on market interest rates.)

Advantages Of A Debt Consolidation Loan

Debt consolidation loans come with a number of advantages, including:

  • Lower interest rates, especially compared to those charged by credit cards, payday loans, auto loans, some student loans, etc.
  • Lower monthly payments
  • Fewer bills to pay each month
  • Possible improvements to your credit score – with fewer credit card loans, and very likely fewer late payments, your credit score could improve

What Are The Risks Of A Debt Consolidation Loan?

Debt consolidation loans aren’t for everyone. 

  • You may not qualify for one if your credit is bad or you don’t have a stable source of income.
  • You won’t be able to use a cash-out refinance or a home equity line of credit if you don’t own a home or if you haven’t built up equity in your home.
  • You have a habit of running up debt, consolidating it, then running it up again without paying off the consolidation loan. This type of loan is designed to help you get out of debt, not to free you up to acquire even more of it.
  • You may lose your home. Any time you take out a loan using your home as collateral, there is the risk that you may, at some point in the future, be unable to make the required payments on your loan, which could result in your losing your home.

How Much Can I Save With Debt Consolidation?

It depends on how much debt you consolidate, the interest rates on the debts you eliminate versus the new loan interest rate, how long it is refinanced for, and a number of other factors.

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But, on average, most people who get a debt consolidation loan find their monthly expenses reduced by hundreds of dollars each month. 

Plus, they’ve got the freedom of knowing all that debt isn’t continuing to pile up at incredibly high rates, while only paying off a small portion of their actual debt each month. Once you’ve got a debt consolidation loan you’ll probably find yourself saying something like “it’s nice to finally be able to breathe again…”

Do I Have To Consolidate All My Debts?

Absolutely not. Which ones you choose to consolidate are totally up to you, within the limits of your loan.

Do Debt Consolidation Loans Typically Work?

Debt consolidation loans typically combine multiple high-interest loans into a single, lower-interest loan. They can work incredibly well for those with multiple high-interest credit cards because they lower your interest rates, monthly payment requirements, the number of payments you have to make each month, and the risk of missing payments.

Will Taking Out A Debt Consolidation Loan Reduce My Credit Score?

It may, at least temporarily.

If you are right up against the acceptable limit of debt for your amount of income, taking out a debt consolidation loan could push you above those limits. However, if you cancel the credit cards and other debts, those cancellations could take you back down below that limit restoring your credit score over time.  

However, if you keep those credit cards and other debts and use them to pay for other purchases (adding additional debt,) then yes, you will probably hurt your credit score.

What Is The Minimum Credit Score For A Debt Consolidation Loan?

Credit requirements differ by lender and type of loan you are seeking. 

Unsecured personal debt consolidation loans usually require a score of around 650.

Cash-out refinancing loans often require a credit score of around 620.

There are specialists who may offer you loans if your credit score is lower, but keep in mind that the lower your credit score requirements, the higher the interest rate they will probably charge.

About the Author

Scott Schang

A 20+ year veteran of the Mortgage and Real Estate industry, I am passionate about educating and empowering consumers. I have been writing about consumer protection issues and making sense of complicated real estate and mortgage topics on this website since 2007

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