What Is A Consolidation Loan, and How Can It Save Me Money?
The most common type of mail I find in my mailbox that tell me I’ve been pre-qualified for a consolidation loan. I get one almost every day. They boast that one of these loans can save me money on my monthly bills. But what exactly is a consolidation loan, and how can a consolidation loan save me money?
What Is A Consolidation Loan?
A consolidation loan is one that people use the loan funds to pay off other smaller debts. For example, let’s say a person has the following debts:
- Credit Card #1 : $8,000
- Credit Card #2 : $1,000
- Credit Card #3 : $1,500
- Personal Loan : $4,000
If a consolidation loan is taken out for an amount of $14,500, all four debts can be paid in full. In other words, the four debts have been consolidated into the single new loan.
Advantages of Consolidation Loans
- Lower Interest Rate : A typical credit card has an interest rate of 12% – 25%., while an unsecured consolidation loan currently hovers just under 10%. With the lowered interest rate, less of each monthly payment goes towards paying interest charges.
- Finite Term: Consolidation loans have a finite term, whether it be 1, 3, or 5 years. After making a consistent payment amount each month for the specified term, the debt is paid in full. If only the minimum payment is made on credit card debt, it could take much longer (in some cases close to 30 years!) to completely pay off the debt.
- Simplify Finances : In the simple example given, the borrower will now make a single payment instead of 4. With less bills to remember to pay, the borrower’s finances are greatly simplified.
- Lower Monthly Payment: Depending up on the interest rates and minimum payment policies of the debts being consolidated, it’s very possible that the borrower could actually lower their monthly payment. That is, the payment of the consolidation loan is less than the sum of the monthly payments of the original 4 debts.
Disadvantage of Consolidation Loans
The advantages listed above make consolidation loans sound like a great idea, yet many financial experts warn people against them. The reason is the consolidation loan pays off the credit cards, providing the opportunity for the borrower to rack up even more debt by continuing to use them. The key to any successful debt elimination effort is to not just put yourself in the best possible solution to pay off the debt, but also to address the spending patterns that caused the debt in the first place.
Consolidation loans are a viable option for people looking for a clear path to debt elimination as well as in some cases an immediate improvement of their cash flow. If the borrower can address the spending habits that created the debt in the first place, consolidation loans can help them down the path to financial freedom.
Brought to you courtesy of Brock
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Brock is a software engineer by day and personal finance blogger at night. He is a fitness junkie and enjoys grilling and smoking meat. Married with two children, Brock strives to improve his skills as a husband and father, and is always on the lookout to stretch his family’s budget as far as he can.
This is a good explanation of the pros and cons of consolidation loans.If you don’t address what got you into debt in the first place, then consolidation loans just might enable you to rack up even more debt. But, if you truly use it to get into a better financial position, then they can really speed up the debt free process.
Thanks for pointing out the negatives to consolidated loans. It didn’t really look like there were any to me, but you’re right, for some people debt is more of a chronic problem.