A debt consolidation loan is a type of installment credit that you can use to combine all your debts unsecured debts into one payment with one lender. You get a personal loan with a fixed interest rate and use the funds you receive to pay off credit cards and other unsecured debts. This is not the only type of financing that you can use to consolidate debt, but it’s often the best option because of its versatility and lower risk.
Personal debt consolidation loans: The basics
- Type of loan: Unsecured personal loan (no collateral required)
- Term: 6-60 months
- Loan amount: $1,000 to $50,000
- Recommended interest rate: 10% or lower
- Payment structure: Installment (equal payments distributed over the term of the loan)
- Fees: Original fees between 1-5% of the amount borrowed
- Purpose: Pay off credit cards and other unsecured debts at a lower fixed interest rate
- How it works: Use the funds from the loan to pay off existing debt, leaving only the loan to repay
Why is 10% the recommended interest rate?
The annual interest rate on personal loans ranges from around 5% up to over 50%. However, for the loan to be beneficial, the interest rate must be significantly lower than the rates on the credit cards you wish to consolidate. If the annual interest rates on your credit cards are 15-20 percent, then it follows that you need a much lower rate. A loan 10% APR will generally be the most beneficial.
Understand Your Options
Using debt to get out of debt faster
It may seem counterintuitive that taking on more debt can help you get out of debt, but a consolidation loan works by minimizing interest charges. You take high-interest rate debt from credit cards and pay it off with a loan that has a much lower interest rate. This leaves only the loan to pay off.
You only have one bill to pay each month, instead of juggling multiple credit card payments throughout the month. What’s more, since the APR is significantly lower, you can pay off the debt faster, even though you may pay less each month.
Debt consolidation loans work because they allow you to restructure your debt, so you can pay it off more efficiently.
When is a debt consolidation loan the best option?
A debt consolidation loan is generally the right choice for getting out of debt when you are still in control of your finances.
You have good credit
You need to have a good credit score (650 or higher) in order to qualify for a low-interest rate. This means if you’ve started missing payments because you’re juggling bills, a consolidation loan may not be the best option.
You can afford the monthly payments
Another key consideration is to make sure you can afford the monthly payments on the debt consolidation loan. If you are struggling to make the payments each month, then consolidation can make your situation worse.
You also need to make sure you can balance your budget, including building savings to cover emergencies and unexpected expenses. Otherwise, you are likely to put these expenses on credit cards and run up new balances.
This calculator can help you determine if you will be able to afford the payments on a consolidation loan. Use your monthly credit card statements and other bills to total up your debt and then calculate the estimated payments you would have with a loan.
If you find that a debt consolidation loan is not the right fit for your credit and budget, there are alternative relief options you can explore. This includes credit counselling, debt settlement, a consumer proposal, and bankruptcy.
Other lending options that consolidate debt
An unsecured debt consolidation loan is not the only financing option that allows you to consolidate debt.
Balance transfer cards
Another lending option that doesn’t require collateral to consolidate debt is a balance transfer credit card. These specialized types of credit cards are designed to consolidate existing credit card debt with low or no APR.
Each balance you transfer incurs a small fee of 3-5% of the balance transferred. Many of these cards offer 0% APR for a limited time on balance transfers when you open the account. This allows you to pay off debt interest-free for a time.
Unlike consolidation loans, balance transfers are solely used for consolidating credit cards. With a consolidate loan, you can also consolidate unsecured personal loans, utility bills, collections, unpaid tax debt, and court-ordered debts such as child support arrears.
Equity lending options for homeowners
If you own a home, you also have a range of secured home equity lending options to consolidate debt. These include:
- A home equity line of credit (HELOC)
- Mortgage refinancing
- Home equity loan (second mortgage)
To use these options, you must have equity available in your home. Equity is the appraised value of the property minus the remaining balance on the mortgage. You can generally borrow up to 80% of the equity you have available.
Using equity to pay off debt has its advantages. You can often qualify for a lower interest rate than you can get with an unsecured loan. Even if you have less-than-perfect credit, lenders may be willing to extend you the credit because you’re using your home as collateral.
However, this also increases your risk of foreclosure. If you default on any home equity lending option, the lender has the right to start foreclosure actions against you. By contrast, if you default on an unsecured debt consolidation loan, the lender does not have a right to any property.Free Debt Evaluation