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 the others is usually a matter of preference weighed against with your credit score and financial situation.

The information below can help you understand how a debt consolidation loan works, how you can use it to overcome your challenges with debt and what you need to know about the risks involved with using this method. If you still have questions or would like to talk confidentially with a credit counsellor 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. The way you’re approved may depend on your debt-to-income ratio
    1. Your DTI must be below 41% to qualify
    2. If the loan plus your current debts puts 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. If the loan plus 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 you are approved with direct disbursal, you’ll complete the underwriting process, but the way the money is distributed will change.
    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. Amounts will be paid out to match the amounts listed in your credit report during the underwriting review process
    3. If you have any money left over, they will send or transfer that money 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 on debt consolidation loans

When you take out a 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) and interest rate you should aim for.

The term of a debt consolidation loan really 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 really 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, so 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 applied to your debt enough to be truly beneficial. So if you qualify at a rate of 12% then you may need to 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 mentioned above might actually 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?

The nice thing about a taking out a personal debt consolidation loan is that you have greater flexibility in what types of debt you can consolidate. Generally, the other do-it-yourself option for consolidation – the balance transfer credit card – is generally only used 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.

You also need to consider with each debt that you consolidate if it’s worth it or if there would be a better option. 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 individual debtor. Consolidated Credit’s experts recommend that you contact the hospital or doctor’s office where the debt was originally incurred (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 really 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.

In fact, you can do the same thing with an auto loan if the rate is right and you have a low enough balance left. 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 take out any loan or even get a credit card you have an option between a secured version 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 so if you default you put your home at risk of foreclosure. Loans can sometimes also be secured with other collateral, like a car or an asset worth significant cash value. If you default on these, the collateral is repossessed. In some cases, such as a secured credit card, the line of credit is secured using a cash deposit as collateral that is used to repay any debt incurred 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 an unsecured debt because you’re given a credit line based on your credit score without the need for a security deposit.

Debt consolidation loans can be secured or unsecured, but it 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 a debt consolidation to consolidate your credit cards and medical bills. Neither of those types of debt is secured. So as much as the collectors on said debt may threaten, they can repossess any property of yours or garnish wages or anything like that without a court order.

However, if you use a home equity loan to consolidate those debts and then default because you can’t make the payments, your home is now at risk of foreclosure. So taking out the loan increased your risk in a way that’s really not worth it in most cases.