Debt Consolidation Loans – What They Are and How They Work

A debt consolidation loan is a type of financing that is extended to people that have multiple debts, allowing them to consolidate (or combine) all of their debts into one new loan.

While debt consolidation loans can be used to consolidate various types of personal debt, the most common is credit card debt. The loan is intended for people with multiple credit cards who are struggling with making the minimum monthly payments to their creditors.

Benefits of Debt Consolidation Loans

The benefits of a consolidation loan can be a worthwhile solution to climbing out of debt for candidates with heavy debt that is dispersed amongst multiple credit cards.  Essentially, when taking out a consolidation loan, you are paying your credit card debts in full and the new loan is established in their place.  Taking out a consolidation loan is beneficial in the following ways:

  • May reduce the number of collection calls you receive from multiple creditors
  • Allows you to make one monthly payment to one source
  • Provides you the opportunity to improve your credit score over time by making timely payments

Secured vs. Unsecured Debt Consolidation Loans

There are two basic types of consolidation loans – secured and unsecured.  Secured loans are tied to an asset (house, car, piece of property) and used as collateral in the event that you default on your loan.  Unsecured loans are not tied to an asset and are based largely on your credit history because you are considered high-risk for a lender.

Secured Loan: positives and negatives

+ Easier to obtain from a lender

+ Higher borrowing amount allotted

+ Lower interest rate

+ Possible tax deductible interest rate

– Longer repayment terms (higher cost in interest over time)

– Risk of losing assets

Unsecured Loan: positives and negatives

+ No asset risk

+ Shorter repayment term (lower cost in interest over time)

– Harder to obtain from a lender (high risk borrower)

– Lower borrowing amount allotted

– Higher interest rate

– No tax benefit

How Will a Debt Consolidation Loan Affect My Credit?

A debt consolidation loan can provide an opportunity to improve your credit if you use it as a financial plan, as opposed to just shifting debt around.  When you take out your consolidated loan, your credit card debt will be paid in full and you will focus on paying down your single new loan.

If you need to take out a consolidation loan, it is safe to assume that your credit has already taken a hit with delinquent payments.  As your score won’t immediately improve, timely payments on the new loan will start to positively impact your credit rating over time.

Helpful Tips to Remember When Entering Into a Debt Consolidation Loan Agreement

  1. Do your research.  Different banks offer competitive loan rates and varying repayment terms.  Keep your options open, as often times Credit Unions can contend with the bank’s competitive rates as well.
  2. Stick to a budget.  Before you settle on your consolidation loan’s monthly installments, measure your income against your expenses to determine a realistic monthly payment.
  3. Make the loan a top priority. Don’t inquire about your eligibility for new credit card promotions or run up any additional debt on your existing cards, as both of these will have a negative effect on your credit score.