Debt Consolidation Loans Pros and Cons

Debt consolidation loans can help to lower your monthly payments, but these loans are not right for every person in every situation. A debt consolidation loan is a new loan with new terms, interest rates and fees, completely separate from your other debt. A borrower uses the funds from a debt consolidation loan to pay-off existing debt, effectively replacing the old debt with new debt. The new debt should have more favorable terms and payments than the combined old debt for a debt consolidation loan to be a good idea. Often, the better financial choice is to simply continue making the separate payments on each of the old accounts, but in some situations, a consolidation loan can offer significant benefits to the borrower.

Debt consolidation loans offer several pros to the borrower, but must be reviewed in conjunction with the cons to determine if this type of loan is a smart financial decision in your particular situation. If you are in a temporary financial hardship, the cons of a consolidation loan can quickly outweigh the pros. Consider speaking with your lenders individually to work out an arrangement that you can handle until your situation improves. If you have no other options, seek a debt consolidation loan, but attempt to do so before your credit takes a plunge from late payments on your existing loans if possible. A poor credit history will make it more difficult to obtain a consolidation loan and may make the terms of the new loan unappealing. The benefits of a debt consolidation loan include:

• Lower monthly payments than the total of the payments made to the old loans
• Lower interest rate than some or all of the interest rates on the old debts
• One payment each month instead of several monthly payments which is much easier to track
• Possible increased credit score from line items on your credit report being paid in full. Each line item paid increases your credit score up to 20 points on average. Credit score increases are not guaranteed and are based on many factors, so your score may or may not go up after receiving a debt consolidation loan.

Debt consolidation loans really have only one con, but it is a big one that can cost you quite a bit of money. Replacing existing debt with a debt consolidation loan often means a new loan with a longer term than the term of the previous debt. This essentially means that even if you receive a favorable interest rate, you may still end up paying more for the consolidation loan debt because of the extended term.

For example: you have two loans. The first has a balance of 5,000, an interest rate of 6 percent and a payment of $96.66 per month. The term remaining on this loan is five years, so this loan will cost a total of $5,799.60 (96.66 X 60 months). The second loan has a balance of $10,000, and interest rate of 8 percent and a payment of $155.86 per month. The term remaining on this loan is seven years, so the loan will cost a total of $13,092.24 (155.86 X 84 months) if paid on-time each month. Together, these loans will cost $18,891.84 and take eight years to pay in full.

The proposed debt consolidation loan terms you have received in your quote are as follows: $15,000 (the balances owed for the two loans above), 6 percent interest rate and 15 year term. The quoted interest rate is lower than one of the previous loans, so it looks like it might be a good consolidation loan. The payment will be $126.58 per month, which is $125.94 lower than the payments you are currently making each month. However, this loan will cost a total of $22,784.40 over the life of the loan, $3,892.56 more than your previous debt. So, the decision is simply a matter of which savings is more important. Would you prefer to save a little each month, or tough it out to pay the debt off sooner with a lower total cost?

*Note: There is a much more complicated method of calculating the total cost of a loan which banks use, but that method is not necessary for the purposes here. The formulas result in a slight difference, usually no more than a few cents. Please consult a financial planner who will be able to provide recommendations based on your situation and your exact loan terms and amounts.