What is a Debt Consolidation Loan and How Does it Work? - Definition, Advantages, Disadvantages and Interest Rates
If you are wondering what a debt consolidation loan is and how it works, it is where a bank, credit union or finance company provides you with the money to pay off your outstanding credit card debts and "consolidates" them (brings them all together) into one big loan. This is the definition of a debt / bill consolidation loan in the simplest terms. Someone usually applies for a consolidation loan when they are having trouble making their minimum monthly payments. There are many advantages and disadvantages to getting a loan like this, and some requirements you will have to meet in order to get it.
How Does a Debt Consolidation Loan Work to Pay off Debt?
A debt consolidation loan pays off debt because a lender will loan you the money to pay off your existing debt by lending you the money you need to do that. For example, if you have 3 credit cards and you owe a combined $20,000 on them, when you ask your lender for a consolidation loan, if you qualify, they will lend you the $20,000. Then, typically, they will pay off your existing credit cards with the money, close those credit card accounts, and then you make one monthly payment to your lender for the $20,000 you borrowed.
Unfortunately, what can happen if you don’t have a realistic household budget that you actively use, after a few months of making loan payments, you are struggling again and re-apply for new credit cards. When this happens, you can actually end up doubling your debt, rather than paying it off with a consolidation loan.
Advantages of a Debt Consolidation Loan
The main advantage of a debt consolidation loan is that your current debt is paid off. Those credit cards that you’ve been struggling to pay, household bills, and even overdrafts on your bank accounts. Unsecured debt consolidation loans take the pressure off of paying lots of different bills each month, even those that are past due.
- You only have one monthly payment to worry about
- You often consolidate at a lower interest rate which saves you money
- Your debt will be paid off in a set amount of time (typically 2 -5 years)
- There usually aren’t any fees if you borrow money from a bank or credit union
What Is the Best Debt Consolidation Loan or Should I Enter Into a Debt Repayment Program?
We often hear someone ask what is the best debt consolidation loan or program, and that all depends on someone’s situation. Loans and debt repayment programs function quite differently. With a loan you borrow money to pay off debt. Then you pay off the loan plus interest. With a repayment program you use money in your budget and pay off your debts without borrowing more money. Instead, when you repay your debts through a repayment program with a non-profit credit counselling service, your lenders will typically reduce or completely waive interest and fees going forward. That’s why you’re able to use the money in your budget more effectively, and get out of debt more quickly.
A debt consolidation loan can often seem like a really good idea. Unfortunately, most people don't reduce the overspending that created their debt, and so they need another consolidation loan once they finish paying off the first one.
Disadvantages of a Debt Consolidation Loan
Lenders are careful when they approve unsecured debt consolidation loans. To qualify for one of these you would typically need to have solid income, a high net worth (the value of your assets after you subtract all of your debts) and a very strong credit score or a co-signer who has a very high net worth and a very strong credit score.
- They often require security (collateral)
- You must have a decent credit rating
- Interest rates are usually higher than a home equity loan (refinancing your home)
- Interest rates for unsecured debt consolidation loans can be high
- If you don't address the problem that caused the debt in the first place, you may need another consolidation loan after paying off the first one
Banks and credit unions usually offer the best debt consolidation loan interest rates. Many factors can help you get a better interest rate, including your credit score, your income, your net worth, whether or not you have a relationship with that financial institution and whether or not you can offer good security (collateral) for a loan. Good security for a debt consolidation loan will often be a newer model vehicle, boat, term deposit (non-RRSP) or another asset that can easily be sold or liquidated by the bank if you don't make your loan payments.
For the past decade, banks have typically charged interest rates on debt consolidation loans of around 7% - 12%. Finance companies tend to charge anywhere from 14% for secured loans to over 30% for unsecured loans. Interest rates for consolidation loans heavily depend on your situation.
How to get a debt consolidation loan is a qualification process. Each lender has slightly different rules to follow, but typically, what is required to qualify for a consolidation loan includes:
- A credit score that meets the lender’s minimum requirement (meaning: not too many late payments and no big negative notes on your credit report)
- you earn enough income
- your total monthly minimum debt payments aren't too high
- you can offer some good security for a loan
If you don't quite meet all of these requirements on your own, you may still be able to qualify if you can find a good co-signer.
When a Debt Consolidation Loan Won’t Work - No Budget, Minimum Payment too High, Bad Credit, No Security
One of the main reasons why a debt consolidation loan won’t work is that someone doesn’t use a realistic household budget. It’s important to manage routine bill payments, loan payments and annual expenses (those seasonal or emergency expenses that are easy to forget about) when you have a consolidation loan.
There are however, also reasons why someone might not qualify for a debt consolidation loan:
- If your minimum monthly debt payments (see our debt consolidation loan calculator) are too high, even after a consolidation loan is factored in
- If you have bad credit
- If you can't offer some reasonable security for a loan
If you’re wondering how do you consolidate debt, or what the best consolidation loans are, when you’ve been declined by a lender, then it’s time to get help considering other consolidation options.
What Is a Debt Consolidation Loan and Where to Get Help
Some people aren’t sure what a debt consolidation loan is, or what the best way to consolidate credit card debt may be for their situation. For expert advice and guidance about the best consolidation loans and alternative consolidation options, contact us to speak with an experienced Credit Counsellor. We will help you find the right solution before it's too late. Speaking with one of our non-profit Credit Counsellors is completely free and confidential. No matter how complicated your situation may be, they will provide you with information so that you can figure out the best solution.
Here's some more helpful information about debt consolidation loans.
Loan Repayment Calculator
If you consolidated all your debts into one loan, what would the monthly payment be? If you can only afford a certain payment each month, how big would your loan be? Find out with this calculator.
How to Get Good Debt Consolidation Advice for Free
If thinking about debt consolidation options seem a little overwhelming or if you just want to speak with an expert to find out what is best for your situation, there are two great places you can go to get free advice.