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How Do Debt Consolidation Loans Work?

Last updated Jan 30, 2024

Tired of managing multiple bills, due dates, and creditors every month? Looking to streamline your finances and save some time and money? Then debt consolidation might be for you! In this article we’ll cover the basics of debt consolidation loans, how they impact your credit, and why you should consider a debt consolidation loan.

For starters, what is debt consolidation?

What is debt consolidation?

Debt consolidation is the process of combining multiple debts and payments into a single debt with a single monthly payment. Debt consolidation helps you simplify your monthly finances by reducing the number of bills you have to manage and budget around. Debt consolidation can also help you save money by lowering your interest rate, your monthly payment, or both. In the best cases, debt consolidation can also help you pay off your debt faster with better terms, and can even boost your credit score!

Some people consolidate their debt payments by transferring their debt to a low-rate balance transfer credit card. Using balance transfer cards can be a good strategy for saving on interest in the short term, but the rate typically goes up after a brief introductory period and is subject to change on an ongoing basis. It can also be hard to remain diligent about spending with an open-ended credit card, which may lead to you racking up even more debt. Lastly, it can be hard to qualify for balance transfer cards with good interest rates unless you have excellent credit.

Another great way to combine outstanding debts is with a debt consolidation loan. In addition to streamlining your payments, debt consolidation loans offer other benefits like fixed rates and payments, a predictable payback schedule, and more.

What is a debt consolidation loan?

A debt consolidation loan is a personal loan that you use to combine multiple debts with multiple payments into a single debt with one monthly payment. Most debt consolidation loans are fixed rate installment loans, which means they have a fixed interest rate that never changes and set number of equal payments. If you have an outstanding balance on four credit cards, you could use a debt consolidation loan to pay off those credit cards, leaving you with just one monthly payment to manage instead of four.

How does a debt consolidation loan work?

The process of consolidating debt with a personal loan is pretty straightforward.

  1. First, determine how much debt you want to consolidate. Add up your outstanding balances on your credit cards or other high-interest accounts.
  2. Next, check your rate for a fixed-rate personal loan. Explore all your debt consolidation options. As you evaluate personal loan offers, make sure you understand the rates and terms of your new loan and that you can afford your new monthly payment. Choose the offer that best meets your needs.
  3. Use your new loan to pay off your high-interest debts. Now, instead of owing money on multiple accounts and making multiple payments each month, you’ll have one loan and make one fixed monthly payment each month. Easy!

Will debt consolidation impact my credit score?

Your credit score depends on a variety of factors. Consolidating your debt will probably impact many of those factors, potentially boosting your credit score in the process. Here’s what might change:

Credit utilization ratio

Your credit utilization ratio measures how much of your total available credit limit you are using. Using a personal loan to pay off existing credit card debt will improve your credit utilization ratio, which may improve your credit score. Remember, it’s important not to run up your credit card balances again or you’ll end up back where you started, or worse.

Credit Mix

Another factor impacting your score is your credit mix – the different types of credit accounts you have, particularly how much installment debt vs. revolving debt you have. If you use a debt consolidation loan to replace some credit card debt, you’re adding an installment account to your credit profile in place of some revolving accounts. This will diversify your credit mix, which can boost your score.

Payment History

The biggest factor impacting your credit score is your payment history; even one late payment can hurt your score. If streamlined monthly payments will help you pay on time, every time, then debt consolidation can offer a huge boost to your credit score by helping you avoid late payments.

Credit Inquiries

Another thing to keep in mind is that when you open a new account (such as a new debt consolidation loan), the lender will typically perform a hard inquiry on your record at the credit bureau. A hard single inquiry won’t tank your credit score, but it may cause it to dip slightly for a few months. Shopping around for the best rate is a good idea, but make sure you protect your score when you apply for new credit.

How is debt consolidation different from debt settlement?

When you consolidate your debts, you combine multiple debts from multiple creditors into a single debt with one payment and one rate. Debt consolidation doesn’t reduce your total balances, but it does reduce your number of monthly payments and it can help you save money with lower interest rates, better terms, or both. The consolidation process is relatively straightforward and can often be completed in a week or so.

On the other hand, debt settlement is the process of negotiating with creditors to settle an outstanding debt for less than what you owe. Although paying back less than you owe may seem like a more attractive option, debt settlement agreements often leave a negative mark on your credit history for up to seven years, which can have a serious impact on your credit score and your ability to access credit in the future. In most cases, debt settlement is recommended as a last resort when you are unable to repay a debt by any other means. Debt settlement is generally a lengthy process, that involves multiple negotiations with your creditor.

Why should I consolidate my debt?

If you’re looking to simplify your monthly finances, save money on interest, and make more progress on paying down your debt, then debt consolidation may be a good fit. Here’s what’s in it for you:

Streamline your monthly debt payments

Save time and energy by making one single payment each month, instead of managing multiple bills for different creditors with different due dates. In addition to peace of mind and simplicity, you can reduce your chances of missing a payment when you only have one bill to manage.

Get a fixed rate and payment you can budget around

Most credit cards have variable interest rates that can go up at any time. With a debt consolidation loan through Upgrade, you lock in a fixed rate for the life of your loan. With a predictable rate and monthly payment, there are no surprises, making it easier to create and stick to a monthly budget.

Know your exact payoff date

Personal loans through Upgrade are fully amortizing with a fixed term. That means you’ll be able to circle the date on your calendar when you’ll be done paying back your debt. On the other hand, most credit cards have variable rates and are revolving debt, which means you have no set payoff date, ever.

Make faster progress on paying off your debt

Making the minimum payment on your credit cards isn’t enough if your goal is to pay off your balances quickly. Minimum payments go almost entirely to interest, which means you’re hardly making a dent in your balance.

On the other hand, with a debt consolidation loan through Upgrade, you’ll be making principal and interest payments each month, making big strides toward paying down that balance.

Save money on finance charges with a lower rate or better terms

Securing a personal loan with a lower interest rate than your credit cards can help you save money in the long run. Even if you get a personal loan offer with a similar rate to your credit cards, you may end up saving money if you get on a fixed payment schedule and make faster progress on paying down your debt.

Boost your credit score

There are many factors that impact your credit score, and a debt consolidation loan can help with lots of those factors. For starters, consolidating your high-interest debt into a single debt will improve your credit utilization ratio. If you can get your utilization ratio below 30%, it will likely give your score a boost. Reducing your revolving balances and replacing them with one installment account will diversify your credit mix, providing another potential boost to your credit score. Lastly, by streamlining your monthly payments you reduce your likelihood of missing a payment, and payment history is the biggest factor impacting your score.

No impact to your credit to check your rate

The good news is that checking your rate for a debt consolidation loan through Upgrade won’t impact your credit score and has no obligation, so why not check your rate and see what you qualify for? You could be on your way to debt consolidation in just moments.

Still on the fence? Check out this detailed article on reasons to consolidate your debt.

How to stay on track with your debt consolidation loan

Debt consolidation loans offer a lot of perks, but only if you stay on track!

The most important thing is to use your debt consolidation loan like you intended – pay off that debt. It can be tempting to set aside some of your new funds for something fun, but then you run the risk of ended up in more debt than you started with. Check out these debt paydown strategies and pick one that works for you.

Once you’ve consolidated your debt, make sure you don’t run up your balances again. Create a budget that you can stick to, implement some everyday habits to rein in your spending, and try these hacks to avoid overspending. If you’re truly ready for a big change, get serious about getting out of debt for good. Check out more tips on staying on track with your debt consolidation loan.

Taking control of your payments with a debt consolidation loan is a great idea – get started with Upgrade today.

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