As the name suggests, debt consolidation is just a form of refinancing of the debt into one single loan, so that there is only a single payment per period to take care of. Not only that, but one also gets to reduce the interest rate that they pay on their debt. Refinancing is a fairly common practice in the world of finance. Whether its large corporations, who may issue new bonds at lower interest rates to pay off the older bonds, or an individual who may seek a new loan on their house so they can reduce the interest rates on their mortgage, it is a fairly common practice to save costs on financing.
Debt-consolidation loan is just like any other personal unsecured loan. That means one wouldn’t need to put any collateral if the application is approved, and the loan would be in the name of an individual or multiple individuals if one applies with a co-signer. This also means that such a loan carries a higher risk for the lender because they don’t have any direct means to recuperate the money in case the borrower fails to pay back the loan, which is why the interest rates tend to be higher on these personal unsecured loans compared to other forms of loans like an auto loan or a mortgage. It generally ranges around 15% - 18% APR but can go as high as 30%. However, the proceeds from the loan are used to pay off the credit card debt which also carries high interest rates. It can be as high as 30% APR. So, it still can be a good option. These loans carry a fixed term which can range from anywhere between 3 and 7 years and have equal monthly instalments to be paid from the month after receiving the proceeds. Like any other type of personal loans, whatever income you use in the application, you would need to provide documentation to verify that number. For example, if you are a salaried individual, then most lenders would ask for the last 2 paystubs. If you are a self-employed individual, then most lenders would ask for tax returns along with the relevant schedules.
But when is it good to opt for this type of loan? What often happens is that people often look at the total interest they would pay on the credit card debt and compare that with what they would pay with the debt consolidation loan. Let’s take a look at an example. Let’s say you have a total credit card debt of $15,000 at a combined average APR of 21%. Assuming you only make minimum payments on the card, those payments may start at around $637 and go as low as $45 by the end. But you would pay a total interest of over $10,000 and pay off the whole debt in over 11 years. Compare this same amount in a debt consolidation loan at 15% for 5 years. You would have to make 60 total payments of about $357 each. That would mean that you would pay a total interest of about $6,411. Therefore, a saving of about 36% in the interest costs. While this is significant in savings, people often overlook the monthly payments aspect of it. What is interesting in this example is that if you continue with the minimum payments on the credit card, then your monthly payments would keep decreasing each month. That is because as the debt amount lessens, so does the interest amount, which is why a new minimum payment due is calculated each month which would be lower than the previous month. After about 24 months of minimum payments, the monthly payments would fall below the $357 monthly payment threshold that you would owe if you were to go down the route of a debt consolidation loan. By the 60th month, that minimum payment would have reached around $142.
This is why whenever a debt consolidation loan option comes up, one should always compare both aspects of the payments to the current credit cards payments. Monthly payments as well as total interest payments. In most scenarios, if the interest rate you qualify for on a debt consolidation loan is lower than the credit card interest rates, a debt consolidation loan would help in reducing your costs but in certain circumstances where you want to save or invest your money instead of servicing your debt immediately, continuing with the credit card minimum payments might give you more time to achieve those goals but at the risk of higher overall interest cost. There is also another benefit to a debt consolidation loan. If one does get approved for a debt consolidation loan, then it adds positively to the credit profile. This is because as you use the proceeds from the loan to pay off the credit card debt, you reduce your credit utilization and also with new personal loan, you add to your credit mix. Be sure to weigh your options before applying.