Debt Consolidation Loans

Using a personal loan to consolidate your debts into one payment

You probably already know that debt consolidation comes in a variety of flavors. So using a personal loan to consolidate debt is simply one option you have out of several. Choosing this option over others is a matter of preference.

The information below explains how a debt consolidation loan works and the risks involved with using this method. If you still have questions about your debt, call us at 1-844-402-3073 to speak to a credit counsellor.

Basic instructions for using debt consolidation loans

A debt consolidation loan is just a regular personal loan that you take out with a specific purpose.

  1. First, you determine how much money you would need to pay off all of the debts you want to pay.
    1. This can be credit cards, medical bills, payday loans, other personal loans – any debt that you want to roll into this one payment
    2. This usually doesn’t include bigger loans like your mortgage or auto loan, or special loans like federal student loans (more on these later)
  2. You apply for a personal loan through your preferred lender or even better, shop around for the best rate in the amount you need.
    1. You can do both either online or in person.
  3. The lender will review your credit and the debts listed in your credit report to make sure you qualify
  4. They may approve you depending on your debt-to-income ratio if:
    1. Your DTI must be below 41% to qualify
    2. The loan plus your current debts put your DTI under 41% then the lender will approve you and disburse the money to you so you can pay off your other debts
    3. Your current debts push your DTI over 41% but your DTI would be less than 41% once the other debts are paid off, then the lender will require “direct disbursal” which means they send money directly to your creditors to pay off your other debts
  5. If you’re approved without direct disbursal, you’ll finish underwriting; in most cases, this is handled through docu-sign so they email you the documents which you sign electronically before sending back or uploading to a secure website.
    1. The money will then be transferred directly to your account
    2. You must distribute the appropriate payments to clear away each of your other debts
  6. If they approve you with direct disbursal, complete the underwriting process. However, the way they distribute money changes.
    1. Once underwriting is complete and all documents are signed, the lender will send payments to each of your creditors to eliminate your outstanding debts
    2. They pay amounts to match the amounts listed in your credit report during the underwriting review process
    3. If you have any money left over, they send the remainder to you once all of your other debts are paid
  7. Once the consolidation process is complete, you should only have the loan to pay off, since all of your other debts should be eliminated.

Target term and interest rates

When you take opt for debt consolidation, the amount is fairly easy to determine – you choose an amount that covers however much money you need to eliminate your other debts. Still, that doesn’t say anything about the term (how many payments the loan extends for) or interest rate you should aim for.

The term of a debt consolidation loan depends on the amount you owe and the monthly payments you can afford. The longer the term, the lower the monthly payments are on the same amount of debt. So if you have a $10,000 loan with a term of 3 years that’s 36 payments around $300 (depending on the rate you qualify for), versus the same loan with a term of 5 years, where you make 60 payments that – depending on the interest rate – should be less than $200.

Most experts agree a debt repayment plan should take five years or less for it to be effective. Otherwise, it generally costs too much in interest charges and effort to be worth it. In which case, you need to find a different, more efficient way to pay off your debt. So aim for a term that’s 60 payments or less that fits your budget. Remember, it’s better to pay off debt quickly than to let it linger. Go for the shortest term possible where the payments won’t over-stress your budget.

As for the interest rate, that will largely depend on your credit rating. However, you should target an interest rate below 10% APR. Any more than that usually means you’re not reducing the rate enough to be truly beneficial. So if you qualify at a rate of 12%, weigh your options to see if you can’t find a better solution.

Also, keep in mind as you weigh the rate you qualify for that the benefit of the low rate will be dependent on what kinds of debts you consolidate. If you have half a dozen credit cards to consolidate that all have over 20% APR then that 12% rate might be good. On the other hand, if you’re consolidating medical bills that don’t have any interest applied, then even a low-interest rate is going to add to the total cost of what it takes to pay off your debts.

What types of debt can I consolidate with a loan?

A personal debt consolidation loan gives you flexibility in what types of debt you can consolidate. People generally use the balance transfer credit card only to consolidate credit card debt. Using it to pay off other debts can be tricky.

With a personal debt consolidation loan, you can ask the lender to disburse the money for any debt you want to pay off, really, but you just have to be careful that you’re not making those debts ineligible for using other relief options later. For example, if you use the money from a consolidation loan to pay off a federal student loan debt, then you become ineligible for federal debt consolidation AND (much worse) public service loan forgiveness.

Many times people use consolidation to handle medical debts along with their other bills. However, medical debt doesn’t have any interest rate, so you have to consider carefully if it’s worth it to consolidate or if you’d be better off using another option for those debts, such as a settlement or payoff plan with each debtor. Consolidated Credit’s experts recommend that you contact the hospital or doctor’s office (not the collector) to see if they will accept a repayment plan first before you consider consolidation on these debts.

In general, people use consolidation loans to pay off the following:

  • Credit cards, store cards, gas cards
  • Medical bills
  • Payday loans
  • Personal loans
  • Private student loans
  • Unpaid tax debt

With unpaid tax debt, keep in mind that you’re not really “consolidating” your debt. You’re just paying off individual years that you owe. To truly “consolidate tax debt,” you usually arrange an installment agreement (IA) through the IRS if you need a repayment plan to pay off multiple years of tax debt with one bill schedule. What you can do is use a consolidation loan to pay off the remaining balance on an IA.

You can do the same thing with an auto loan with the right rate and low balance. If you have a low amount to repay and you can get a better interest rate on the consolidation loan than what you have on your existing auto loan, then you pay off the balance and roll it into the consolidation amount.

Secured vs. Unsecured

When you get a loan or credit card you have an option between a secured and an unsecured version.

Secured means the loan is back up by some type of collateral. For example, in a home equity loan, you borrow against the value of your home. If you default you put your home at risk of foreclosure. You can secure loans with other collateral, like a car or an asset worth significant cash value. If you default on these, the collateral is repossessed. A secured credit card uses a cash deposit as collateral to repay any debt if the borrower fails to pay.

An unsecured loan refers to any loan that doesn’t require collateral. Traditional credit cards are an example of unsecured debt because you do not need a security deposit.

Debt consolidation loans can be secured or unsecured. In almost every circumstance you only want to use an unsecured personal loan to consolidate your debt. Experts warn against secure debt consolidation loans, such as a home equity loan, because they add undue risk.

Consider that you’re using debt consolidation to consolidate your credit cards and medical bills. Neither of those types of debt is secure. Collectors can repossess any property of yours or garnish wages or anything like that without a court order.

If you use a home equity loan to consolidate and default, your home is now at risk of foreclosure. So taking out the loan increased your risk in a way that’s not worth it in most cases.

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