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Debt Consolidation Loan: Compare Personal Loans and Other Options

| MoneyRates Personal Finance Specialist.
min read

credit-cards-vs-personal-loansIf debt consolidation is right for you, you can choose from several methods. One of those options is a personal loan for debt consolidation. If you consolidate debt with a personal loan, you can put an expiration date on your debt, improve your credit score almost immediately and work toward financial security.

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Personal Loan for Debt Consolidation

If your credit cards are maxed out, or you have too many accounts with balances, or you'd just like to pay a lower interest rate, debt consolidation might be right for you. Debt consolidation with a personal loan offers a few advantages:

  • Fixed interest rate and payment
  • Pay multiple accounts with one payment
  • You repay your balance in a finite term
  • Personal loan interest rates are lower than credit card rates
  • Lower credit card balances can increase your credit score quickly

One problem with credit cards is the minimum payment. Consumers often get too comfortable with it, and this does little to pay down the balance. In fact, making only the minimum payment can cause your debt to hang around for decades. Even if you stop using the card. If you owe $10,000, pay the average credit card rate of 17% and make a minimum payment of $200, it would take 88 months to zero it out. And you'd have paid over $7,500 in interest.

But a personal loan with the average rate of 10% and a five year term only increases your payment by only $12. And you'll be free of your debt in five years (60 months) and pay just $2,748 in interest.

When Debt Consolidation Is Right for You

Debt consolidation with a personal loan may be right for you if you meet these requirements:

  • You are disciplined enough to stop carrying balances on your credit cards
  • Your personal loan interest rate will be lower than your credit card interest rate
  • You can afford the personal loan payment

If all of those things don't apply to you, you may need to look for alternative ways to consolidate your debt.

When Debt Consolidation Won't Work for You

Not everyone is a good candidate for debt consolidation. And if they try it, they could end up worse off. So hold off consolidating debt with a personal loan if:

  • You don't have the discipline to leave your credit cards alone
  • Your personal loan interest rate won't be lower
  • You can't afford the personal loan payment

There are alternatives for those who won't benefit from a personal loan. Those solutions are explained in detail later in this article.

When you don't have the discipline for debt consolidation

You know yourself. If you are not 100% sure of your ability to leave your credit cards alone once you pay them off, don't consolidate debt with a personal loan.

You may benefit from credit counseling with a reputable non-profit association, and perhaps a DMP (debt management plan).

When your personal loan interest rate won't be lower

Personal loan interest rates average about 7% lower than credit cards for the same borrower. But if your credit rating has suffered since getting the cards, you may not be able to get a better interest rate. You may want to work with a credit counselor in that case.

If you have credit cards with low (or even zero) introductory interest rates, it would be silly to replace them with a more expensive loan. However, some accounts offering zero interest also have a clause that allows the creditor to charge you a high interest rate back to Day One if you don't pay off the balance before an established deadline. In that case, you may want to use a personal loan to clear it before the penalty rate kicks in.

When you can't afford the personal loan payment

If you are just squeaking by making the minimum payment on a fistful of credit cards, you may not be able to lower your payment with a personal loan. That's because many credit card issuers set a very low minimum payment on the account. This maximizes their revenue as long as you make the minimum payment.

But a personal loan is designed for payoff after a specific number of months. That can easily increase your payment even if your interest rate drops.

Alternatives to Debt Consolidation With a Personal Loan

For those who can't benefit from debt consolidation with a personal loan, there are options. Here they are from least drastic to most drastic.

Consolidate debt with a balance transfer credit card

If you can clear your debt in 18 months or fewer, this can be a great solution. Consumers with excellent credit can get up to 18 months interest-free. The transfer charge is normally about 3%. Make sure that you clear your balance in time, however. Many issuers charge deferred interest all the way back to Day One if you don't pay the account off during the zero-interest period.

Consolidate with a home equity loan

If the consolidated payment is too high, one way to lower it is to stretch out the repayment term. And the best way to do that is probably a home equity loan. This fixed-rate loan can have a 15 or even 20-year term and the interest rate is very low. That's because the loan is secured by your house.

A $5,000 personal loan with a 5-year term and a 10% interest rate has a $106 payment. On a 15-year 7% second mortgage, it's $45. But the total interest cost of the 5-year loan is $1,374, while the 15-year loan cost is $3,089. In addition, second mortgages often have higher fees and setup costs. But if you really need to lower your payments, a second mortgage is a good option.

Debt management plan (DMP)

A debt management plan, or DMP, is a program under which you make a single monthly payment to a credit counselor or debt management specialist. These firms often provide credit counseling and budgeting advice as well. And they can often negotiate lower interest rates and payments from your credit card issuers.

When you enter into a plan, understand how much of what you pay each month will go to your creditors and how much will go to the company. Find out how long it will take to become debt-free, and make sure you can afford the payment. If you won't clear your debts with five years of paying as much as you can afford, many experts recommend that you consider a Chapter 13 bankruptcy.

Chapter 13 bankruptcy

Why is bankruptcy less drastic than debt settlement? Because it often takes a lower toll on your credit score than debt settlement, especially debt settlement gone wrong.

Chapter 13 bankruptcy is a debt management plan. However, Chapter 13 filings create public records, so it's not private. One advantage is that with Chapter 13, your creditors have to participate. They can't opt out the way they can with debt management or settlement plans. Once you file, the Bankruptcy Trustee determines what you can realistically afford and sets your monthly payment. Then the Trustee, just like a credit counselor or debt management specialist, distributes your payment among your creditors. In (usually) five years, any remaining debt is discharged. Discharged amounts are not taxable income.

Debt settlement

Debt settlement, if successful, can unload your account balances, collections and other unsecured debt for less than you owe. You generally offer a lump sum and ask the creditor to accept it as payment-in-full and write off the remaining unpaid balance.

If you don't have a lump sum, you stop paying your creditors and instead deposit the money you would have paid with a settlement company. Or you can settle the accounts yourself and deposit the money into your savings until you have enough to offer as payment-in-full. Meanwhile, you will be fielding collection calls. Your creditors may even choose to take you to court. The months of late payments and calls, possible collection accounts and potential lawsuits can make debt settlement harder on your credit score than bankruptcy. And any amounts forgiven by your creditors are subject to income taxes.

If you are very lucky and/or a very good negotiator, you can pay about 50 cents on the dollar and come out with the debt reported "paid as agreed" on your credit history. But you'll most likely get, "account settled for less than the amount owed." In addition to a slew of missed payments. That is very bad for your credit history and score.

Chapter 7 bankruptcy

Chapter 7 bankruptcy is the legal, public version of debt settlement. As with a Chapter 13 bankruptcy, your creditors must participate. Chapter 7 bankruptcy is for those who can't afford to make any payment to reduce what they owe. You must pass a "means test" and prove your insolvency to qualify for Chapter 7 bankruptcy.

The disadvantage of Chapter 7 bankruptcy is that you cannot withhold possessions from the court. They must be sold to satisfy your creditors. One advantage of debt settlement is that it allows you to keep all of your possessions. You just offer money to your creditors, and if they agree to take it, your possessions are safe. With bankruptcy, discharged debt is not taxable income.

Keys to Successful Debt Consolidation

Consolidating debt with a personal loan can be smart. You can save money and improve your credit rating. Follow these tips to ensure a successful debt repayment:

  • Find a personal loan with a lower interest rate than you're currently paying
  • Make sure that you can afford the payment. Sometimes, to repay debt quickly, your payment must increase
  • Consider combining a personal loan with a zero-interest balance transfer card
  • Control your spending, or get professional counseling
  • Stop using your credit cards and stop carrying balances.

The worst thing you can do is run up your credit cards again once the balances are zeroed out. The most important thing to remember about consolidating debt with a personal loan is that you still owe the money. Moving debt from credit cards to a personal loan does not make it magically disappear. But stick with your repayment schedule, refrain from using your cards, and watch your balance disappear in time.

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