Consolidation loans can help manage payments and reduce your interest rates, but they are subject to certain drawbacks as well. Before applying for these loans, you should carefully examine their pros and cons.
A consolidation loan refers to a personal loan that you take out to repay your existing loans. Consolidation does not literally mean combining your existing short-term high-cost debts. It simply means using funds of a new loan to discharge current outstanding debts.
There are some facts that you must know about these loans.
- Personal loans only combine small lump sum loans such as payday loans, instant loans, and bad credit loans. They cannot merge instalment loans such as personal loans, mortgages, and auto loans.
- If you have credit card bills, they cannot be consolidated into a personal loan. You will need to apply for a balance transfer card.
- Consolidation loans charge fees. This will be between 1% and 5% of the total amount of the loan.
- Consolidation does not guarantee that you will qualify for lower interest rates.
- You should have a good credit history to apply for these loans. Few lenders accept applications from bad credit borrowers, but they charge high interest rates.
- There is no guarantee that you will be able to merge all existing debts. Chances are you will end up dealing with most of them separately.
What are the positives of consolidation loans?
A debt consolidation loan from a direct lender brings loads of benefits. Here are some of the advantages:
- You will have fewer bills to manage
Consolidation is sought-after by those who are struggling to keep up with payments of multiple debts. With consolidation, you do not have to manage multiple debts. You can reduce the number of accounts. Instead of making multiple payments, you will be making only one payment every month. You can easily track payments each month.
Consolidation loans cannot help reduce the amount of debt, but even so, it helps free you up from the burden of multiple payments. One of the biggest reasons why borrowers seek consolidation loans is that they find a way out to manage payments.
- There is a possibility of saving money
Another benefit of consolidation loans is that they can help save money. If your credit history is stellar, you will be able to qualify for lower interest rates. If you are struggling to keep up with payments, you should immediately talk to your lender. Falling behind on payments will result in credit score damage. Afterwards, applying for a consolidation loan will not benefit you at all.
Having said that, consolidation loans combine short-term high-cost debts such as payday loans and bad credit loans. If you fall behind on payments of these loans, they are rolled over, which sharply increases the total cost of the debt due to interest penalties and late payment fees.
Of course, you can save a lot of money on interest by combining these debts into a personal loan. A consolidation loan will spread the cost across months.
If you have outstanding credit card bills and you successfully manage to apply for a 0% balance transfer card, you do not have to pay interest provided you settle the whole outstanding balance within the introductory period.
- Consolidation helps build your credit history
Another benefit is that they will help protect your credit score. If you pay down the debt on time, you will see a significant improvement in your credit score. Consolidation actually does not let your credit score become even worse, which is possible with handling all debts individually.
What are the negatives of consolidation loans?
Undoubtedly, consolidation loans have some benefits, but they are subject to some downsides too. You should also keep in mind the drawbacks before considering consolidating your debts.
- They charge processing fees
Though there is a possibility of qualifying for lower interest rates, but despite that, you will not save any money. Do not forget that consolidation loans charge processing fees. You will have to pay between 1% and 5% as upfront fees. If you choose to apply for a balance transfer card, the fees could be between 3% and 6%.
- You might not qualify for a favourable deal
Even if your credit rating is perfect, there is no guarantee that you will end up with a favourable deal. Your creditworthiness will be evaluated before approval. This plays an important role in deciding on interest rates, loan amount, and repayment terms. If you have outstanding debts or credit card bills, you will likely be offered deals that actually help save you money.
Fortunately, you can consider a debt management plan if you cannot qualify for better consolidation deals. A debt management plan will enable you to pay less than the agreed debt amount as per your affordability, but there is a catch. These plans severely damage your credit score.
- There is a risk of accumulating debt
Consolidation or balance transfer frees up debt, but there is always a possibility of accumulating more debt. Now the whole amount of the debt will be paid down across months, so you might tend to borrow more money as your budget has some breathing space.
You should carefully identify the cause of falling into debt. Try to change your financial behaviour so you do not rack up debt. If you keep overspending money, you will never be able to get out of debt. There is no point in consolidation of your loans if you do not want to turn over a new leaf.
- Consolidation can hurt your credit score
Consolidation leads to hard inquiries. They lower your credit points. However, the effect is temporary. Once you settle the debt, your score will automatically improve. If you choose a balance transfer card, the credit utilization ratio will immediately increase, which lowers your credit score.
The final word
Consolidation could prove to be an effective solution when you are struggling with multiple debts. They have some pros and cons. Make sure you understand them before deciding whether these loans are suitable for you.
