What Is Loan Consolidation?

Loan consolidation simply means combining multiple debts into one. Loan consolidation is another name for debt consolidation. It can help you organize your payments, lower your monthly expense and reduce the interest rate you pay.

This article covers these topics:

• Why consolidate loans?

• How does loan consolidation work?

• Student loan consolidation

• Credit card consolidation

• Personal loan consolidation

• Types of debt consolidation loans

• Getting started: preparing for loan consolidation

• Alternatives to loan consolidation

• What is loan consolidation: FAQs

It’s also very important to choose the right consolidation loan with an affordable payment. 

If you do those things, loan consolidation could leave you with a debt burden that is much easier to handle. This article will help you understand what you need to know to make the right decisions about loan consolidation.

Even if you’re keeping up with your debt payments, loan consolidation may save you money if your interest rates are high and you carry balances from month to month. 

Why Consolidate Loans?

Combining multiple debts into one does not “wipe out” your debt – it just changes it. So, does loan consolidation just the problem around?

Not with a good consolidation product and strategy. Here are some of the things loan consolidation can do:

• Simplify your debt payments. Even if you have automated bill payments set up, having different amounts coming out of your bank account at various times can lead to mix-ups. Boiling it all down to one monthly payment makes it easier to keep track of your money. 

• Reduce your monthly payments. This can be accomplished in a variety of ways. Loan consolidation can reduce your monthly costs by extending your repayment period, reducing your interest rate, or both.

• Lower your interest cost. This is often the biggest benefit of loan consolidation. Replacing high-interest debt with a lower-interest debt consolidation loan can reduce both your monthly payments and interest charges.

• Improve your credit score. From lowering your credit utilization ratio to helping keep your payments on track, debt consolidation could increase your credit score.

• Speed up repayment. If your interest rate is lower, more of your payment goes toward reducing your balance. So if you continue to pay the same amount, your debt will shrink faster. And if you choose a consolidation loan with a shorter term, you’ll be forced to pay your debt off sooner. Just make sure that the payment is affordable.

You might not accomplish all of the above goals with your loan consolidation program. However, if you can accomplish one or more of them, you may find it well worth your while. 

How Does Loan Consolidation Work?

Certainly, the benefits of loan consolidation can sound tempting. So how does this work?

The simple answer is you take out a new loan and use the proceeds to pay off other debts. However, you have to get the details right to make sure this works to your advantage. 

Your first task is deciding why you want to consolidate – do you want to pay less interest, reduce your payments, speed up debt repayment, or replace variable rate accounts with a fixed-rate loan?

You can manage the size of your monthly payment by lengthening or shortening the repayment period of your consolidation loan. Just be advised that while a longer repayment period can give you lower monthly payments, it may raise your total interest expense in the long run. 

The best form of loan consolidation gives you a lower interest rate. If the consolidation loan has a higher rate, it only makes sense if you’re trying to replace variable-rate loans with a fixed rate, or because you need to extend repayment to make it affordable – and a lower rate isn’t available. 

You’ll also want to decide which debts to include in loan consolidation. If you’re trying to lower your interest, you’ll only consolidate accounts with higher rates. Mortgage debt is typically a bad candidate for loan consolidation. Mortgage rates are generally relatively low, and repayment terms are usually already pretty long. 

The following sections of this article will take a look at some types of debt you might consider for loan consolidation. Following that will be a discussion of how to find the right loan to consolidate these debts into. 

Student Loan Consolidation

Student debt comes in a variety of forms. The most common is government-sponsored student loans. However, there are also some private student loans. Plus, students sometimes have to use credit card debt to finance some of their student expenses.

You should think very carefully before you refinance government-sponsored student loans. They offer a variety of payment programs and borrower protections that private loans don’t. Plus, government-sponsored student loans generally have fairly low interest rates.

Private student loans don’t usually offer the same types of special advantages for borrowers. So, private student loans might be good candidates if you can find a new loan with a lower interest rate.

If you used a credit card to meet student expenses, it could be an excellent candidate for loan consolidation. More on why credit card debt should be a prime target for debt consolidation is discussed in the next section. 

Credit Card Loan Consolidation

According to the Federal Reserve, during the first quarter of 2022, the average credit card interest rate was over 16%. At the same time, student, personal, auto, and mortgage loan rates were all below 10%.

In other words, credit card debt is especially expensive. When you’re looking to reduce debt, it makes sense to prioritize getting rid of your most expensive debts first.

This makes credit card debt an excellent candidate for debt consolidation. Its high interest rates mean that getting rid of it will do the most good, and it should be relatively easy to find a consolidation loan with a lower rate.

Make sure that consolidating your credit card debt doesn’t simply clear your balances so you can start running up new charges again. Consolidation works best when it’s part of a broader program to live within your means.

Personal Loan Consolidation

It might be a good idea to consolidate any personal loan balances you have outstanding, depending on the circumstances. 

Two main conditions that determine whether personal loan consolidation makes sense are:

• Whether you can find a lower-interest alternative to replace your current personal loan debt

• Whether there are no prepayment penalties on your existing debt that would negate the benefits of replacing it

You can also use loan consolidation to help organize your personal loans and change the repayment period. However, lowering your interest rate is the best way to save money.

Types of Debt Consolidation Loans

There are several kinds of consolidation loans. The right one for you depends on your goal, loan amount, and financial resources.

• If you have equity in your home, a cash-out refinance mortgage might be a good option. These often have relatively low interest rates. Just make sure you’re confident in your repayment plan before you put your house up as security on a loan. Understand that cash-out refinancing comes with surcharges that apply to the entire loan, not just the cash-out. That can make it very expensive.

• Home equity loan or line of credit (HELOC). Home equity loans have lower closing costs and can be completed faster than cash-out refinancing, although the interest rates are higher. They are good for larger loan amounts. HELOCs have lower setup costs – a few hundred dollars or even zero. Their interest rates are variable, though, so you might want to use one for smaller amounts. Home equity financing has a long repayment period, so it’s great for keeping payments low.

• If you have reasonably good credit, a personal loan might work for loan consolidation. And applicants with excellent credit can find rates that compete with home equity rates. You should be able to get a personal loan with a much lower interest rate than most credit card debt. Personal loans have fewer moving parts and fees than many home equity loans.

• A balance transfer credit card with a low introductory rate is a good option if you can pay off your debt fairly quickly. These often offer a 0% interest rate for the first six to 24 months, so if you can pay off your debt within that time frame they can save you a lot on interest charges. Just watch out for balance transfer fees, which range from 1% to 5% and average 3%.

Getting Started: Preparing for Loan Consolidation

Once you identify the type of loan or credit you can use to consolidate your existing debts, there are three things you should check:

1. Compare your current monthly payments with what your new monthly payment would be to make sure you know what you’re getting into.

2. Create a realistic budget for your new monthly payment. 

3. Add up the total cost of your new loan, including interest and fees. Compare that to the total cost you’d pay if you continued paying off your current loans as scheduled. 

Checking these things will help you be clear on whether your loan consolidation plan will meet the goals you intend.

Alternatives to Loan Consolidation

If you’re struggling with debt and can’t find a loan consolidation plan that solves your problems, there are alternatives. These may be more drastic measures than loan consolidation, but they might be necessary to address serious debt difficulties:

• Debt management is a plan you create with the help of a credit counselor. Besides helping you organize your debt, a credit counselor may be able to negotiate with creditors to lower your interest rate, waive certain penalties or reduce your monthly payments. That won’t reduce what you owe, but it might make repayment easier to handle. However, fees for these services can diminish their effectiveness, and the payment might not be affordable.  

• Debt relief can reduce the amount you owe. If you can prove you’d be unable to pay the full amount, a debt relief firm may be able to negotiate with creditors to less than you owe as payment in full. A percentage of what you save would be kept by the debt relief firm as a fee. You may also owe income tax on forgiven amounts, and it will almost certainly damage your credit score, at least in the near term.

Again, debt management and debt relief are more drastic solutions than loan consolidation. Before you resort to them, it’s well worth checking out whether loan consolidation would solve your problems.