Using debt consolidation loans to pay off other debt is controversial but could save you thousands
This one is going to be controversial! I’ve written a few times about using debt as a tool and the debt naysayers send me emails every time. I can already imagine the comments about this post, that you should focus on paying off debt outright and using a debt consolidation loan is just a form of robbing Peter to pay Paul.
Debt gets a bad name but it’s just a tool. If you’re using credit cards and loans to buy crap you don’t need or really want, then it’s like trying to drive a nail with a screwdriver. Use debt to leverage what you have, like buying a roof over your head or paying for college, and you can accomplish much more than you would otherwise.
In fact, many of the same debt naysayers that reject all debt are also the ones using credit card programs to accumulate points for free trips. Even if you pay the card off every month, it’s still using debt to do something good.
Once you understand debt as a tool, you can start to see how to use debt consolidation as a way to improve your finances.
How to Use Debt as a Tool
The idea of using a debt consolidation loan to pay off debt is to lower your interest rate and the money you end up paying on your loan. Maybe your credit score wasn’t so great when you took out the loan or maybe you just didn’t have any credit at all. Giving yourself six months to improve your credit score can mean a big difference in rates you get and the interest you’ll pay on loans.
Step 1 – Give yourself a little time to improve your credit score
Not all online loan sites or debt consolidation loans are created equal. If your credit score is 660 or higher, you might qualify for a peer loan on Lending Club where rates tend to be a few percent lower. If your credit score is below 660 then Avant usually offers the lowest rates among bad credit personal loans. It doesn’t hurt to shop around a little because loan sites won’t run a “hard” inquiry on your credit until you approve the loan terms. Whatever you do, stay away from payday lenders and other cash advance sites that will offer monthly loans.
Step 2 – Shop around for the best rates on debt consolidation loans
Make a commitment to use your debt consolidation loan responsibly. I hate saying that. We all know we should use debt responsibly and try to spend within our budget but shopping is so much fun. Try using a pre-paid cash card instead of credit cards. Check out these five budget tricks that actually work or some of the other ways to save money on the blog.
Step 3 – Pay off your debt and keep it paid off
Using Debt Consolidation to Pay off Debt
You can use a personal loan or p2p loan for any purpose but debt consolidation is the #1 reason for loan requests on most sites. Even with bad credit, you can usually get a debt consolidation loan that is several percent cheaper than your credit card rates.
Not only can a debt consolidation loan lower the interest rate on your debt but it can help improve your credit score. Personal loans go on your credit report as non-revolving debt, the kind with fixed payments and a payoff date. Credit rating companies see this kind of debt as better than revolving (credit card) debt with changing payments and that may never be paid off.
An important feature of personal loans and debt consolidation loans is that you can pay the loan off at any time without a prepayment penalty. Try budgeting a little extra to your personal loan to pay it off as early as possible.
I put together a little example to show the benefit to lowering your interest rate and getting on a fixed payment schedule with a debt consolidation loan. The graph compares two loans, both for $5,000 but one on 22% credit cards and the other on a 36-month personal loan at a 14% rate.
Most credit cards set your minimum payment around 2% of the outstanding balance, dragging out your payments and interest forever. Instead, I put the monthly payment at $150 to be a little closer to the $170 payment you would have with the debt consolidation loan.
Paying just an extra $20 a month on a debt consolidation loan saves you more than a year of payments and over $1,150 in interest on the debt. Beyond the time and money you save, you will have been building your credit for three years with non-revolving debt and should have a stronger credit score once you’re done.
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A debt consolidation loan isn’t a golden ticket to spend but it also isn’t the black hole that many debt naysayers think it to be. Take advantage of debt as the tool it is and to get yourself back on track.