In our consumer society, it's easy to get into debt. Not only have expensive "luxuries" like smartphones and high-end electronics become the norm, the average American is often dealing with car payments, student loans and other nonmortgage loans. That can mean struggling with multiple debts, each with its own interest rates and schedules.
It can be tempting to scrap the whole juggling act by taking out a single debt consolidation loan and dealing with a single, lower monthly payment. Before you take either route, however, be sure you understand what debt consolidation is and how it works.
What Are Debt Consolidation Loans?
A debt consolidation loan is simply a loan you take out in order to pay off several debts, and you then pay off the debt consolidation loan. Most people take out a personal loan for debt consolidation, but some may choose a home equity loan. These often have even lower rates, but your home is collateral, which you could lose if you miss payments.
How Do Debt Consolidation Loans Work?
The process is simple. You apply for the loan just as you would any other loan. There may be fees associated with applying. If you take out a home equity loan for debt consolidation – which is not a good idea – then you may have home appraisal fees and other paperwork expenses.
When you receive the money, you then pay off the other debts. This leaves you with only one loan – the consolidation loan – to pay. Usually, these loans have lower monthly payments than the combined payments you were making on all the separate loans.
While this might provide some financial breathing space, it can also be a trap. Depending on the length of the loan, you could end up paying more in interest than if you had simply continued on your current payment path.
Say, for example, you have three loans: a student loan, a personal loan for a car, and a credit card you're making large payments on, which you have been paying off steadily so that by September 2016, your debts looked like this:
If you continued as you are, you'll pay $559 a month to pay off all your debts in September 2031, having paid $15,326 dollars in interest just for these 15 years. Let's say you decide to consolidate the loans instead, still aiming to pay them off in 15 years. If you took out a loan for $25,000 to pay off these loans, and got a 9.5 percent interest rate, you could pay only $261 a month, but you'll have spent $21,990 in interest to do it, even with the lower overall interest rate. If, for some reason, you got a consolidation loan at 11 percent interest, your payments would be $284 a month, with $26,146 in interest – more than the loan itself!
So when is a debt consolidation loan ever a good idea? When you make more than the minimum payments. Let's look at two scenarios: one in which you continue to pour the entire $559 into the loan, and another where you reduce that to $450 a month:
A final route for those with excellent credit and the ability to pay off debts quickly is to take out a zero-interest credit card and transfer the fee. This can be a great way to consolidate debt if you can pay it off in 12 to 18 months, but if you don't, you face getting stuck with hefty penalties or back interest.
Debt consolidation loans can be a good way to relieve some financial pressure, simplify your paperwork, and even get out of debt faster and with less going toward interest. However, be sure you get all the facts, do some math and be smart with your loan. If you are in dire straits and want to examine other alternatives, check out our article comparing debt consolidation, debt management and bankruptcy.