Considering a debt consolidation loan? Here’s what to look for

If you’re barely keeping up with your monthly debt payments, or even starting to fall behind, you might be thinking about making a change. Paying less toward your debt each month probably sounds like a pretty good solution. That’s a possibility with a debt consolidation loan.

This debt relief method lets you roll up all or several of your existing unsecured debts into one lower-interest loan. You can get a debt consolidation loan from a bank or other lending institutions, such as credit unions and online lenders.

With a debt consolidation loan, instead of making multiple payments a month, you just make one. According to Christopher Viale of Cambridge Credit Counseling Corp, someone with “good credit and good discipline” is the ideal candidate for a debt consolidation loan. These loans are meant for unsecured debt, like credit card debt, but not debt like mortgages, which are secured by collateral.

Debt consolidation loan: what to consider

If your goal is to drastically reduce your overall debt, a debt consolidation loan is not a good choice. That’s because it won’t lower the amount of the debt itself. Where you’ll save is in having a loan with a lower interest rate and/or negotiating with your creditors to waive or reduce fees and penalties if you’ve already missed payments.

But if you have good credit and can afford to make a monthly loan payment, a debt consolidation loan is well worth looking into.

To ensure you get the most benefit out of a debt consolidation loan, do your homework on some of the most important factors of these loans.

Related article: How debt consolidation differs from debt management

It’s all about interest

The whole point of a debt consolidation loan is to pay less each month than you’re paying now. You can accomplish that by negotiating a lower interest rate, getting your lender to waive late fees or penalties if you’ve missed payments, or agreeing to lower your minimum payments. Or potentially all of the above.

When it comes to an interest rate, you have to find out exactly how much you’ll be charged and whether that percentage will change. First off, keep an eye on the fees. An interest rate doesn’t tell the whole story. You’ll want to know what the loan’s APR is, which includes all the fees you’ll be charged by the lender. For example, many lenders charge origination fees to cover the cost of processing a loan.

“If the loan has a reasonable interest, but a large origination fee, that interest rate is higher than what is being displayed on the offer,” Viale said.

Sit down and do the math on the interest. Find out if the interest rate is fixed or variable. A fixed rate means the interest rate won’t change over the course of the loan. If the rate is variable, that means it can change, and potentially alter how much you’re paying each month – sometimes dramatically so. Also watch out for “teaser rates” that expire after a certain point. Ask your lender how the rate can or will change over the life of the loan.

You’ll get the best interest rates with a good credit score, typically a score of 680 and above. You may also get a better rate, and have a better shot at being approved for a loan, if you provide collateral. Home equity loans, for example, can be used for debt consolidation. They often offer good interest rates, but the big risk is that your house is on the line if you default on the loan.

How long will you be in debt?

Even if you end up with a loan with a lower monthly payment, if the term of the loan is much longer than your current debts, it could cost you more in the long run. Maybe you’re OK with that if having that extra breathing room allows you to make your payments on time.

You should also find out if the loan has a prepayment penalty, meaning a charge by the lender for paying off your loan early.

Can you really make that monthly consolidation loan payment?

Many people find themselves in the position of looking at a debt consolidation loan because they’re having a hard time making their current payments. If you consolidate your debts, but still can’t afford to make the monthly payment, that will only exacerbate the problem.

Be honest with yourself about how much you can afford. Are you going to change your spending habits so that a debt consolidation loan will work for you? Have you made a budget to decide how much you can afford to pay toward a debt consolidation loan? Have you changed your attitude about carrying debt? Sometimes using a debt consolidation loan may bring relief with no real change.

“Someone might pay off their credit card debt and then start to overspend again,” Viale said.

Accruing new debt on top of consolidated debt just makes the situation worse.

Red flags

Make sure you’re dealing with a reputable lender when you’re considering a debt consolidation loan. It’s a huge red flag if a company guarantees you will get a loan if you pay them a fee in advance. According to the FTC, these advance-fee loan guarantees are not only sketchy, but may be illegal. Legitimate creditors may require an application or appraisal fee, but will never guarantee you will get a loan.

With debt consolidation, you should never be asked to stop making monthly payments to your lenders and instead asked to make payments into a different account. That’s debt settlement, a completely different process.

As with any loan, you should do some comparison shopping. Get estimates from more than one lender and make sure you know exactly how much you’ll pay each month, for how long, and what happens if you miss a payment.

Related article: 5 keys to successful debt consolidation