If you have ever done any loan search, specifically student loans, you have probably encountered the phrase “consolidation loan.” You have also probably seen offers to consolidate multiple credit cards into one. Loan consolidation is often a good idea, but you should know how it works and what these loans do before you jump in.
As with any personal loan, it’s better, of course, to never have to borrow money. A consolidation loan is a personal loan you’d take out if you’ve already borrowed money and hope to make the payment process more efficient and potentially save on interest.
What is a Consolidation Loan?
A consolidation loan is essentially a new loan that pays off multiple old loans. Rather than having, for example, two student loans with different lenders for $5,000 each, you could have one $10,000 loan. That means one payment (and one lender) instead of two. You can do a consolidation loan with either of the two original lenders. Alternatively, you can look for a new third lender if you think you can get better terms.
There is always a “however,” though. If you have two Federal student loans at 4.9% and your consolidation offer is for 5%, then you should keep the loans where they are. Furthermore, if the interest rates are the same, you should probably stay where you are. Consolidation loans have the same set of origination fees as any new loan. Unless interest rates will be lower for a long enough time to save you money on the fees, it is probably best to endure the headache of multiple lenders.
Alternatively, if you have the cash, you could pay one (or both) of the loans off early, making no payments and paying no interest. While this is the ideal option, it won’t be possible for everyone.
Likewise, the same principle is true for consolidating credit cards. Balance transfer offers often come with fees. There may be a temporary no-interest period, but the interest rate eventually increases. Thus, you should only consolidate if you transfer the balance to a card with a lower interest rate.
Pros of Loan Consolidation
- Fewer payments
- Fewer lenders
- Less hassle
Cons of Loan Consolidation
- Possible higher interest rates
- Your new lender might not be as good
Exercise Caution When Consolidating Loans
You should be careful, educated, and calculated if you are moving around debt balances. Treat your loans like you treat your cash. For instance, you wouldn’t decide to move your bank accounts to a company that charges extra fees and pays you less interest. Similarly, you wouldn’t entrust your money to a sketchy guy on the street.
Treat loans the same way, especially because they have a long-lasting impact on you and your credit. Be smart and only consolidate if it’s the right thing to do. Remember that a hard inquiry a lender runs on your credit history can ding your credit score, so try to shop around for loans in a smaller window of time to keep the damage confined.
Student Loan Consolidation
If you’ve taken out loans to attend school, you most likely have Federal Stafford loans from at least one bank. Taking loans from two or more banks means you must make two or more monthly payments for those loans.
Let’s say you have two loans, and in about seven months, they’ll come due. When that happens, you might consider finding a consolidation loan. Here are the key things to remember if you’re a student considering a consolidation loan.
First, do not assume that a consolidation loan will save you money. Federal Stafford loans, the most popular type of student loan, have rates set by the government. If you have two loans with minimum payments of $100 each and you consolidate, they will combine into one payment of $200.
Second, the process might cost you more money if you get a different kind of loan when you consolidate. Make sure that if you have student loans to consolidate, you continue with a Federally backed loan with the same fixed interest rate.
If you’re nervous about the impact of a consolidation loan on your credit score, any negative result should not be significant depending on when you got the first loan. When you consolidate, you close two loans with history and replace them with one brand-new loan, which lowers your average account age and can impact your credit.
Alternative Methods for Saving on Interest
Maybe you’d like to save money on interest payments but aren’t sure that loan consolidation is right for you. Consider these three alternative strategies for managing debt.
Snowballing, for loans, means you pay the minimum payment on all of your loans except for the one with the smallest balance. You pay as much as possible into that loan. Once you pay it off, put all that money into the next smallest debt rather than just lowering how much you put into loan payments.
For example, let’s say you have three loans. One has a balance of $5000 at 4.9% (minimum payment is $150), the second has a balance of $1000 at 5.9% (minimum payment $50), and the third has a balance of $3000 at 7% (minimum payment $100). Which would you pay first using the snowball method?
If you said the second loan, you are right since the strategy here is to pay for the loan with the lowest balance first. It doesn’t matter what the minimum payment or interest rate is. Instead, all that matters is how quickly you can eliminate that first debt.
Another potential approach to paying off debt is called a debt avalanche. Using this method, you’d focus on paying off debt with the highest interest rate first, then moving on to debt with the next highest interest rate once the former is paid off.
Many financial experts prefer the debt avalanche method to the debt snowball method because you’ll save money overall by reducing how much extra debt you take on due to interest.
A debt snowball plan based on the example above would look like this: you make the $50 and $150 minimum payments while putting $200 into the highest-interest loan. Once you pay it off, you start putting that $200, in addition to the $50 minimum payment you were already making, into the 5.9% loan. Then once the second loan is paid, you put the whole $400 into the 4.9% loan. That is the fastest way to pay down all of your debt.
If you own a home and are well on the way to paying it off, then you might benefit from a debt roll-up loan (I just made that term up). I have helped people structure loans like this in the past.
For example, a woman came in with $20,000 in credit card debt, $7,000 remaining on her auto loan, and $40,000 remaining on her home mortgage. That is $67,000 in total debt. Consequently, it would have taken her about ten years and tens of thousands of dollars in interest to pay it all off.
Her home was worth about $250,000, well over her total debt load. She was able to pay off all other debt and have just one mortgage loan payment instead. This refinance and debt roll-up saved her hundreds of dollars a month in payments and thousands of dollars in long-term interest.
The math is simple, so you can look at your debt structure and determine if this is a good idea for you. But think carefully before securing other debts against your home. Your home may be repossessed if you do not keep up repayments on a mortgage or any other debt secured on it.
Loan Consolidation: The Final Word
Building a strong debt management plan is important if you are in a difficult financial situation. If you feel overwhelmed and unable to handle your current situation, you can get debt consolidation help. Moreover, be sure to work with a trustworthy, reputable company that has your best interest in mind.