Should you do a Debt Consolidation Loan?

Perhaps your credit card bills have been piling up ever since you took that vacation to Aruba last summer. Or maybe you had a medical emergency that your health insurance did not fully cover. It could even be that you’re still stuck with some student loans that you took out when you decided to go back to school, and you want to accelerate their payoff. 

No matter what types of bills may be hindering your financial health, a debt consolidation loan is a viable option to help you save money and become debt-free in a reasonable timeframe. However, before taking out a loan, there are several things to consider.

WHERE CAN YOU GET A DEBT CONSOLIDATION LOAN?

The good thing is that in today’s day and age, there are many lenders and financial institutions that offer these types of loans. You can start off by checking in with your local bank/credit union, as this is where you will find the lowest interest rate. If you cannot get approved by them, there are plenty of online peer to peer lenders that offer debt consolidation loans. Upgrade, Upstart, and SoFi are three of the most reputable. While your interest rate through these platforms may be a bit higher, the application process is seamless and everything can be done online. If you would like to compare some of the top rates online lenders, check them out here.

SHOULD YOU APPLY FOR A DEBT CONSOLIDATION LOAN?

Deciding whether to do a debt consolidation loan boils down to two very simple things. Are you lowering your monthly payment and/or interest rate? If you can accomplish one of these (or ideally both), a debt consolidation loan probably makes sense for you. There are many lenders out there who offer these types of loans. 

However interest rates can vary significantly, ranging anywhere from 5% all the way up to 35%. There is no point in taking out a loan at 30% APR to pay off credit cards with an average interest rate of 19%. While it may feel good to get rid of some high credit card balances, a high interest loan won’t benefit you at all. Your monthly payment will be just as high, and you won’t be saving any money on interest. 

In the end, it comes down to a simple numbers game. If you are able to save money on a monthly basis and can lower your overall interest rate through a debt consolidation loan, then you should do it. If not, then stay away and do as best you can to apply more funds to paying down your individual bills. 

COMMON MISCONCEPTIONS

There is a common misconception that by doing a debt consolidation loan, you instantly become debt-free. On the contrary, all you are really doing is transferring your debt from multiple bills to one loan. While it does simplify your finances, the fact of the matter is you still owe money that you need to pay back. Bottom line: A debt consolidation loan isn’t a magic pill that solves your debt problem. It is simply a vehicle to help you become debt-free quicker while saving money in the process. 

Another misconception is that by doing a debt consolidation loan, you will instantly improve your credit score. However, depending on how many inquiries on your credit you have done, applying for a new loan can actually hurt your credit score. While you will be paying off high balance credit cards, you will also have a new loan on your report. Once the loan is paid off, and your overall debt has decreased, you can expect your score to improve.

Lastly, even if you do pay off your debt with a consolidation loan, you should still try to improve your budgeting and personal financial planning. Learn from your mistake of getting into debt, and make sure you stay debt-free in the future. You should keep a log of all of your expenses, and try to do away with any unnecessary expenditures. 

Being debt-free, your next initiative should be to begin building your savings. According to Spendmenot, 69% of adult Americans have less than $1,000 in a savings account, 54% of those aged 45-54 have no savings, and 22% of Americans have less than $5,000 saved for retirement. The key to accruing a substantial amount of savings is to live within your means. Track everything and always be sure that your monthly income exceeds your monthly expenses. 

MISTAKES TO AVOID

A big mistake to avoid at all costs is securing a debt consolidation loan and proceeding to charge on the same exact credit cards you paid off with the loan proceeds. Many people fall into this trap, and it only exacerbates their debt problem. Doing this means that you now have a loan payment to make and also need to worry about paying all of your credit cards. 

Another mistake to avoid is transfering ALL of your debt into one loan. If you have a low interest credit card or an auto loan, which will typically have a lower rate than other unsecured debts, there is no need to include those in the debt consolidation loan. Focus on consolidating only your highest interest bills into the new loan. 

Lastly, despite consolidating your debt, you should still continue to improve your budgeting and financial planning. The reason many people get into debt in the first place is from their lack of a budget. Track all of your spending through a spreadsheet, and know exactly how much of your monthly income goes toward essential bills and discretionary spending. When your total expenses exceed your total income, that is when you know there is a problem and you need to change your habits.

RECAP: 3 TAKEAWAYS

1. Only do a debt consolidation loan if you can lower your monthly payment and/or interest rate.
2. Once you have secured the loan, stop charging on your credit cards.
3. Improve your budgeting so you can avoid incurring debt in the future.

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