Debt consolidation is one of the most effective ways to effectively manage debt. It can greatly improve your debt-to-income ratio and help you get back on your feet. You will have more money in your pocket and less debt to worry about, and while your options are a little more limited if you have bad credit, you can still get a consolidation loan.
In this guide, weâll look at the ways that a debt consolidation loan will impact your credit score, while also showing you the best ways to consolidate credit card payments and find a credit card consolidation plan that suits your needs.
What is a Debt Consolidation Loan and How Does it Work?
A debt consolidation loan can help you to manage credit card debt and other unsecured debts by consolidating them into one, manageable monthly payment. You get a large loan and use this to clear all your current debts, swapping several high-interest debts for one low-interest loan.
Youâll consolidate multiple payments into a single monthly payment, and, in most cases, this will be much less than what youâre paying right now.
The problem is, creditors arenât in the business of helping you during your time of need. Theyâre there to make money, and in exchange for your reduced monthly payment, youâll get a loan that extends your debt by several years. So, while you may pay a few hundred dollars less per month, you could pay several thousand dollars more over the lifetime of the loan.
Why Consider Debt Consolidation for Bad Credit?
You can use a debt consolidation loan to consolidate credit card debt, clear your obligations, reduce the risk of penalties and fees, and ultimately improve your credit score. Whatâs more, you may still be accepted for a debt consolidation loan even if you have a poor credit score and a credit report with several derogatory marks.
Itâs an option that was tailormade for borrowers with lots of unsecured debt, and it stands to reason that anyone with a lot of debt will have a reduced credit score. Of course, it still helps if you have a high credit score as that will increase your chances of getting a low-interest debt consolidation loan, but even with bad credit, you can get a loan that will reduce your monthly payment.
How Does Debt Consolidation Affect Your Credit Score?
A debt consolidation loan can impact your credit score in a number of ways, all of which will depend on what option you choose:
- A balance transfer can reduce your score temporarily due to the maxed-out credit card and a new account.
- If you use a consolidation loan to clear credit card balances, you will diversify your credit report, which can benefit up to 10% of your credit score.
- If you continue to use your credit cards after clearing them, your credit utilization will drop, and your credit score will suffer.
- A new consolidation loan account will reduce your credit score because itâs a new account and because the average age of your accounts has decreased.
- Debt management will reduce your credit utilization score by requiring you to cancel credit cards. This accounts for 30% of your total credit score.
The good news is that all of these are minor, and the short-term reductions should offset in the long-term. After all, youâre clearing multiple debts, and that can only be a good thing.
A debt consolidation loan will not impact your score in the same way as debt settlement or bankruptcy.
Alternatives to a Debt Consolidation Loan
A debt consolidation loan isnât your only option for escaping debt. There are numerous options for bad credit and good credit, all of which work in a similar way to a debt consolidation loan.
These may be preferable to working with a consolidation loan company, especially if you have a lot of unpaid credit card balances or youâre suffering from financial hardship.
How Does a Debt Management Program Work?
Debt management is provided by credit unions and credit counseling agencies and offered to individuals suffering financial hardship and struggling to repay their debts. A debt management plan typically lasts three to five years and works with unsecured debt only, which includes medical debt, private student loans, and credit cards, but not mortgages or car loans.
A debt management plan ties you to a credit counseling agency, which acts as the middleman between you and your creditors. The agency will help to find a monthly payment you can afford and then negotiate with your creditors. You make your monthly payment through the debt management program and they distribute this to your creditors.
Debt management specialists are experts in negotiation and know how to get creditors to bend to their ways. They understand that lenders just want their money and are keen to avoid defaults and collections, so they remind them that failing to negotiate may increase the risk of such outcomes.
Debt management programs are not free. You will be charged a small up-front fee in addition to a monthly fee. However, the amount of time and money they save you is often worth the small charge.
The only real downsides to a debt management plan is that youâll be required to cancel most of your credit cards, which will impact your credit score, and if you miss a single payment then creditors will revert to previous terms and your progression will be lost.
A Balance Transfer
You donât need a debt consolidation loan to consolidate your debt. You can also use something known as a balance transfer credit card.
A balance transfer allows you to consolidate credit card debt onto a single card. These cards offer you 0% interest for up to 18 months and allow you to transfer multiple credit card balances.
As an example, letâs assume that you have the following credit card balances:
- Card 1 = $5,000
- Card 2 = $2,000
- Card 3 = $3,000
- Card 4 = $5,000
That gives you a total credit card balance of $15,000. If we assume an APR of 20% and a minimum payment of $500, you will repay over $20,000 in 42 months, with close to $6,000 covering interest alone.
If you use a balance transfer credit card, you will be charged an initial balance transfer rate of between 3% and 5%, after which you will not be required to pay any interest for up to 18 months. Continue making those same monthly payments, and youâll repay $9,000 before that introductory period ends, which means your debt will be reduced to just $6,000 and can be cleared in 14 months with less than $800 in total interest.
This is a fantastic option if you have a strong credit score, otherwise, you may struggle to find a credit limit high enough to cover your debts. However, itâs worth noting that:
- Your credit score may take an initial hit due to the new account and maxed-out credit card.
- The interest rate may be higher, so itâs important to clear as much of the balance as you can before the introductory period ends.
- You may be charged high penalty fees for late payments.
- You canât move credit card debt from cards owned by the same provider.
What About Debt Settlement?
Debt settlement works in a similar way to debt management, in that other companies work on your behalf to negotiate with your creditors. However, this is pretty much where the similarities end.
A debt settlement specialist will request several things from you:
- You pay a fee (charged upon settlement).
- You move money to a secure third-party account.
- You stop meeting your monthly payments.
They ask you to stop making payments for two reasons. Firstly, it will ensure you have more money to move to the third-party account, which is what they use to negotiate with creditors. They will offer those creditors a lump sum payment in exchange for discharging the debt, potentially saving as much as 90%, on top of which they will charge their fee.
Secondly, the more payments you miss, the more unlikely it is that your account will be settled in full, at which point the lender will be more inclined to accept a sizable settlement.
Debt settlement is not without its issues. It can reduce your credit score, increase the risk of litigation and take several years to complete. However, itâs the cheapest way to clear your debts without resorting to bankruptcy.
You can do debt settlement yourself by contacting your creditors and negotiating reduced sums, but you will need to have a large sum of cash prepared to pay these settlements and youâll also need a lot of patience and persistence. There are also companies like National Debt Relief that can help, as well a huge number of lesser-known but equally reputable options.
Who is Eligible for a Personal Loan for Debt Consolidation?
In theory, you can use a personal loan as a debt consolidation loan. In other words, instead of working with a debt consolidation company and allowing them to set the rates and find suitable terms, you just apply for a personal loan, use it to pay off your debts, and then focus your attention on repaying that loan.
This can work very well if youâre using it to repay credit card debt. The average credit card APR in the US is 16% to 20%, while the average personal loan rate is closer to 6%. A personal loan acquired for this purpose will give you more control over the total interest and repayment term.
However, while you may pay less over the term, itâs unlikely that youâll reduce your monthly payments. A debt consolidation loan is designed to provide an extended-term so that the monthly payment will be reduced, and unless you choose a loan with a long term, you wonât get the same benefits.
The biggest issue, however, is that you need a very good credit score to get a loan that is big enough to cover your debts and has interest that is low enough to make it a viable option. This is easier said than done, and if youâre drowning in debt thereâs a good chance your credit score will not be high enough to make this feasible.
Is it Time for Bankruptcy?
If you have mounting credit card debt, personal loan debt, and private student loans, and youâre struggling to make the repayments or clear more than the minimum amount, you may want to consider bankruptcy.
It should always be seen as the last resort, as it can have a seriously negative impact on your credit score and make it difficult to get a home loan, car loan, or low-interest credit card for many years. However, if youâre not confident that debt settlement will work for you and believe youâre too far gone for debt management and consolidation, speak with a credit counselor and discuss whether bankruptcy is the right option.
You can learn more about this process in our guides to Filing for Bankruptcy and Rebuilding your Credit After Bankruptcy.
Debt Consolidation for Bad Credit Homeowners
If you own your home, you have a few more options for debt consolidation. When you use your home as collateral against a loan itâs known as a secured debt. It means the lender can repossess your home if you fail to meet the repayments. This also eliminates some of the risks associated with lending, which means they offer more favorable interest rates and terms.
Home Equity Loan and HELOC
An equity loan is a large personal loan secured against the value tied-up in your home. You can acquire an equity loan when you own a large share of your property, in which case youâre using that share as collateral.
Interest rates are very favorable, and you can receive a consolidation loan that clears all your debts and leaves only a small monthly payment and easily manageable debt in their place.
A home equity line of credit (HELOC), works in much the same way, only this time youâre given a line of credit similar to what youâd get with a credit card. You can use this credit to repay your debts, after which you just need to focus on repaying the HELOC.
An equity loan and a HELOC provide the lowest possible interest rates of any debt consolidation loan. However, failure to meet your monthly payments will damage your credit score and place your home at risk.
Cash-Out Refinancing for Consolidation
Cash-Out refinancing replaces your current mortgage with a new, larger mortgage. The difference between these two home loans is then released to you as a cash sum, allowing you to clear your debts in one fell swoop.
Cash-Out refinancing is often used to fund a childâs college education or a new business, but itâs becoming increasingly common as a form of debt consolidation, helping American homeowners to clear credit card debt and other unsecured debts.
Reverse mortgages work in a similar way to home equity loans, but with a few key differences. Firstly, they are only offered to homeowners aged 62 or older. Secondly, there is no monthly payment and no other recurring obligations.
A reverse mortgage is only repaid when you sell the home or die. There are also some obligations with regards to maintaining the home and living in it full time, but you donât need to pay any fees and can use the money gained from this mortgage to clear your debts.
Summary: Consider Your Options
A debt consolidation loan is a great option if youâre struggling with debt. You can try a debt management plan if you have bad credit, a balance transfer if you have great credit, and debt consolidation companies if youâre somewhere in the middle.
But as discussed already, these are not the only options. The debt relief industry is vast and caters for every type and size of debt. Do your research, take your time, and make sure you understand the pros and cons of each option before you decide.
How to Get Debt Consolidation Loans When You Have Bad Credit is a post from Pocket Your Dollars.