What is a Debt Consolidation Loan?

The term “debt consolidation” refers to the act of taking out a new loan in order to pay off other liabilities and/or consumer debts. 

Essentially, consolidating your debt means combining all of your unsecured debts into a single monthly payment. You use a debt consolidation loan to pay off all your unsecured debts at once, rather than making individual payments to each of your creditors. Now, that may seem like you’re robbing Peter to pay Paul (in other words, taking on new debt just to cover your current debts). Right? 

Well, not quite. It’s a bit more complex than that. 

While debt consolidation loans won’t solve all of your debt problems, they might help make it easier for you to pay back your loans. Most of all, keep in mind that depending on a particular loan’s terms and your unique circumstances, a debt consolidation loan may or may not be worth it. Here, we’ll take a look at what you need to know about consolidating your debts (and how to find the right option for you). First things first: What types of loans are available? 

Debt consolidation options 

There are two types of debt consolidation loans: Secured and unsecured loans. 

Secured loans are backed by one of your (the borrower’s) main assets, which work as collateral for the loan. In other words, if you were unable to pay off the loan, the creditor would be entitled to seize your collateral as repayment. You can use a valuable asset—such as your car —as collateral, as long as you qualify. 

While secured loans can be a great option for those with less-than-perfect credit, they pose a substantial risk: If the repayment becomes unaffordable, it’s your car on the line.  

Unsecured loans, sometimes referred to as signature or personal loans, are not backed by your assets or collateral. Instead of collateral, unsecured loans are backed by your credit history and income. These factors are used to determine your creditworthiness—the likelihood that you are a dependent borrower that will pay back your loan on time. 

With no tangible incentive to ensure repayment, some creditors may be wary of giving out unsecured loans to high-risk borrowers (those with low credit scores or concerning credit histories). Because of this, they can be more difficult to obtain and tend to have higher interest rates and lower qualifying amounts. Furthermore, if you’re unable to repay an unsecured loan, the lender may commission a collection agency or take you to court. 

Different lenders will offer different loan amounts, depending on your creditworthiness (as well as specific federal and state laws). At Personify Financial, for example, personal loans start at $1,000. Maximum loan amounts vary by state. 

Now that you understand the difference between secured and unsecured loans, you’ll need to determine which one is better for you. 

You’ll first need to check whether you qualify for a debt consolidation loan—and if you do, which type of loan you qualify for. Generally, secured loans tend to be easier to qualify for, as they require collateral. You’ll also need to gather more information about your loan options. Installment loan rates and specifics will vary depending on your state. It’s a good idea to start with the basics and compare the rates and terms of different loans to find what works best for your unique situation. 

Before even comparing different loans, however, you’ll need to ask yourself the following: Should I consolidate my debts in the first place? The answer will depend on your financial situation—namely, how stable it is. 

Here’s what you need to know: 

When to consolidate debts 

If you’re trying to dig yourself out of debt, you’re not alone. According to research, the average credit card debt for balance-carrying households is about $9,333. There are a number of advantages to debt consolidation. It can help you get out of debt and improve your credit score. Furthermore, it can: 

• Make repaying your existing debts more convenient: rather than paying multiple bills each month, all your debts are consolidated into a single monthly payment. 

• Help make monthly payments lower, in many cases 

• Restructure your payment plan into a longer period 

So, if you find yourself overwhelmed or missing payments due to multiple sources of debt, a debt consolidation loan might be right for you. But even then, you’ll need to qualify for it first. 

Do I qualify for debt consolidation? 

 Generally, you’ll need to meet the following main requirements in order to be eligible for a debt consolidation loan: 

• Debt-to-income ratio: this is your monthly payments divided by your gross monthly income, and is sometimes used to determine if you’ll be able to make the monthly loan payments. To qualify, most lenders allow a ratio as high as 30%. In other words, your monthly debt obligations should add up to no more than 30% or less of your gross monthly income. 

• Consistent cash flow to cover payment: You need to show that you’ll be able to make the sufficient payments to eliminate your debt. You may also need to show that you have a plan to prevent running up debt again in the future. 

While convenient, debt consolidation loans may not be the right fit. After all, if debt consolidation were always the right answer, everyone would be doing it! 

When NOT to consolidate debts 

Debt consolidation won’t solve all of your debt problems. It doesn’t address any excess spending habits, for example, and it’s not an instant solution if you feel overwhelmed by debt. The first thing you need to do is to analyze your overall financial situation. If you think it’s likely that you will continue to rack up more debt in the future, you may want to come up with a more long-term solution to addressing your debt. 

Alternatively, if your debt is small enough that you can pay it off within 6 to 12 months at your current pace, just stick to making all your scheduled payments on time. You’d only save a negligible amount by consolidating, so it probably wouldn’t be worth it to take out a new loan. 

If you find yourself struggling with debt but feel that a debt consolidation loan would be excessive, you could, instead, look into other methods to pay off your loans, such as the debt avalanche and debt snowball methods. Talking to a financial planner or advisor may also help you come up with a plan to eliminate your existing debts and prevent yourself from incurring new ones. 

The bottom line 

If you choose to consolidate your debt, you may feel like your burden of debt has been lifted. However, it’s important to note that’s not always the case. When you consolidate your debt, some lenders may charge a fee for their service. So, the amount of money you owe might be different than your original total debt, as you need to consider additional interest and fees. But instead of having multiple accounts to repay - you’ll only have one. 

If you do decide that debt consolidation is the right option for you, there are a few things that you should keep in mind: 

1. Analyze your debt and financial situation before consolidating. 

2. Assess how much you will pay on the consolidated debt. 

3. Identify your financial goals. 

4. Research and check all your available options (which will depend on your state). 

5. Check which debt consolidation options you qualify for. Additionally, consider the different rates and terms that will apply to your unique financial situation. 

Finally, the specific loan amount, annual percentage rate, and the terms you qualify for will depend on your credit, loan repayment history, and employment history (cash flow), among other factors. 

From here, it’s also important you think about your personal preferences. Debt consolidation can be a good choice for getting yourself out of debt—but it’s not the only option. Make sure you explore all the alternatives and do your research before deciding to consolidate your debt. 

Ultimately, if you’d rather have only one account to pay and you’re confident you can make your payments on time, then a debt consolidation loan may be the right option for you.