Debt consolidation with a personal loan: Pros and cons

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In a Nutshell

A personal loan can be used to consolidate debt and repay multiple debts with one monthly payment. While this can simplify the debt repayment process and sometimes save you money, that’s not always the case. You should compare interest rates and research alternatives such as balance transfer credit cards to find the best option for you.
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If paying off debt is your goal, debt consolidation with a personal loan could help you tame multiple accounts at once by channeling them into one monthly bill.

Let’s face it: Making payments to multiple lenders each month can be a hassle. It can also be expensive — especially if some of your debts have a high interest rate. Taking out a personal loan to consolidate debt can sometimes make debt repayment easier and cheaper.

That’s because a consolidated loan may have a lower interest rate than the combined rates on the individual loans you owed.

You can consolidate all different kinds of debt using a personal loan. But first, you’ll want to figure out if it’s your best option.

There are several ways to consolidate debt

Interest rate, repayment term and fees can vary greatly from one lender to another. Shopping around for the best rate and lowest fees could save you money whenever you borrow.

Personal loans

Personal loans can come from banks, credit unions or online lenders.

You can use the money for a wide range of purposes for nearly anything you’d like, including repaying existing debt. Your interest rate will be based on your credit scores, income and other financial details.

You’ll know your repayment timeline upfront, and many lenders have repayment periods from three to five years. Many personal loans are unsecured, which means there is no collateral guaranteeing the loan.

Balance transfer credit cards

Balance transfer cards often have a limited time 0% promotional interest rate that allows you to pay no interest for a few billing cycles. You may have to pay a small fee to transfer the balance, although some cards do not charge for this.

Creditors determine the amount you can transfer to a balance transfer card based on your credit line and the creditor’s policies. Just be aware that interest rates can be high when the promotional rate expires.

Home equity loans

If you’re a homeowner with equity in your home, you could borrow against the house and consolidate your debt using a home equity loan.

Interest rates are generally lower on a home equity loan than on a personal loan, but you must use your property as collateral to secure the loan. This means if you can’t pay back your loan, you could lose your home.

Pros of debt consolidation with a personal loan

There are several benefits to using a personal loan to consolidate debt.

You could reduce your interest rate

Personal loans can have lower rates than other kinds of debt. If you can qualify for a low-interest personal loan and reduce your rate, you’ll save yourself money on loan repayment.

You could lock in a low rate

Sometimes when you borrow money, your interest rate is variable. This means it’s linked to a financial index, such as the prime rate. If the index rate goes up, your rate typically goes up too.

If you’re tired of owing money at variable rates, you could get a fixed-rate consolidation loan so you’ll know exactly what your monthly payment will be each month.

However, the Consumer Financial Protection Bureau warns that although many personal loans have low teaser rates, those rates can go up. Make sure you find out the maximum rate you could be charged for your consolidation loan.

You will have a repayment timeline

When you take out a personal loan, you agree to repay that loan on a set schedule specified in your loan agreement. Since you’ll have your loan term going in, you’ll know exactly when you’ll become debt-free if you pay on time.

Be aware that if you want to pay off your loan early, your lender may charge a prepayment penalty.

You could boost your credit

Your credit scores are based on a number of different factors, each with a different weight. For instance, if you’re unable to pay your credit cards on time, that can negatively affect your payment history — an important factor.

If you’ve maxed out your cards, that can hurt your credit utilization rate. Credit utilization measures the amount of your available credit you use. A lower utilization rate could help your credit scores.

Consolidating your debt with a personal loan could help your credit scores if it leads to a lower credit utilization rate and more on-time payments.

Cons of debt consolidation with a personal loan

There are some potential disadvantages to consider before you decide to use a personal loan to consolidate your debt.

You may pay a higher rate

There’s no guarantee a personal loan will definitely have a lower interest rate than all the debt you pay off. If you consolidate any debt with a lower interest rate, you’ll raise the costs of repaying it. Use a debt repayment calculator to compare any potential savings.

You could end up paying more interest

Even if you lower your interest rate, there’s a chance your personal loan could cost you more if you stretch out your repayment period for too long.

If you use a personal loan with a five-year repayment term when you’d otherwise have repaid the debt in two years, you’ll pay interest for three years longer. This could mean you’ll pay more interest over time, depending on your loan’s interest rate.

For example, say you owe $2,000 on a credit card with 13% interest and are paying $75 a month and also owe $5,000 on a personal loan with 10% interest and are paying $250 a month.

If you refinanced to a personal loan at 8.99% interest for 36 months, you would lower your interest rate but would pay $145 more in interest than if you hadn’t consolidated.

You could get hit with fees

Sometimes you have to pay to take out a personal loan. Depending upon your lender, you could end up owing application fees, origination fees or prepayment penalties if you pay off your loan early.

These fees sometimes make consolidating your debt more costly than just continuing to pay back your current lenders.

You might put assets at risk

Some personal loans are secured personal loans. With a secured loan, certain assets will act as collateral to guarantee the loan.

Lenders could take the assets if you don’t repay as promised. If you take out a secured personal loan to consolidate debt that was unsecured — meaning the debt didn’t have any assets guaranteeing it — you’ve put the collateral at risk.

If you don’t pay back your loan, you could lose the property you put on the line.

You could end up deeper in debt

When you pay off credit cards using the proceeds of a personal loan, you free up your line of credit. If you use these cards again and can’t pay off the balance, you could end up owing your original creditors again.

But now you’d have to pay off your consolidation loan and a bunch of new debt, leaving you in worse shape.

Ask the experts about debt consolidation

When does debt consolidation make the most sense?

“Debt consolidation makes the most sense when you can improve your debt situation in one or more of the following ways: A lower monthly payment, a lower interest rate, a shorter payoff term, or a more secure loan such as with a mortgage. Different people are going to have different objectives for consolidation.”

Melanie Hanson, senior editor, Education Data Initiative

What are the possible benefits of debt consolidation?

“Debt consolidation is a great way to give yourself one, convenient monthly payment instead of having to worry about several different bills with different due dates. Most loans allow you (and encourage you) to set up automatic payment, so as long as the money is in your checking account, you won’t have to worry about ever missing a payment. In addition, debt consolidation gives you a concrete finish line as to when you know all of your debt will be paid off.”

James Lambridis, founder and CEO of DebtMD

What are the potential downsides of debt consolidation?

“If you consolidate your debt using a loan, it will show up as new debt on your credit report and could potentially lower your credit score. Additionally, if you miss any payments on your consolidated debt, it will also negatively impact your credit score. Another potential downside of consolidating your debt is that it could extend the amount of time it takes to pay off your debt, which could mean you’ll end up paying more in interest over the long run.”

— Brian Meiggs, founder of Smarts 

Will debt consolidation impact my credit score?

“Getting a debt consolidation loan can be a net positive for your credit score. You may see your score decrease slightly due to the hard inquiry on your credit to secure the loan. But, since paying off your credit cards will cause your credit utilization ratio to drop, you may see an initial boost to your score. Plus, responsibly managing your debt consolidation loan can help your score over time.”

Leslie Tayne, financial attorney and founder of Tayne Law Group

Bottom line

Consolidating debt with a personal loan can be a good idea if you can get a new loan with favorable terms and a lower interest rate than current debt. Whether you can qualify for a consolidation loan depends on your credit scores, income and other financial factors.

If you qualify, make sure you understand the loan terms, have a plan to pay it back and get your spending under control so you don’t end up deeper in debt. If the conditions are right, a debt consolidation loan can be a good tool to help you become debt free faster.

About the author: Christy Rakoczy Bieber is a full-time personal finance and legal writer. She is a graduate of UCLA School of Law and the University of Rochester. Christy was previously a college teacher with experience writing textbo… Read more.