Taking out one loan to pay off another loan often gets a bad rap. And you do need to be careful to not get into a trap of even MORE debt when you’re trying to do the opposite: get debt free.
However, there are times when you can use a “good for you” loan to pay-off a bunch of “bad for you” loans. This might be taking a personal loan or debt consolidation loan that puts you on a payment plan to pay off expensive credit cards, for example.
Personal or debt consolidation loans could:
Your loan’s rate, repayment term, and loan amount can vary depending on the lender and your creditworthiness. The best offers generally go to applicants who have excellent credit and high income relative to their debt. But even someone who doesn’t get approved for the absolute best loan could still benefit.
Some loans are marketed as debt consolidation loans, but the name refers to how you’ll use the money rather than a specific type of loan. Lenders will generally send the funds to your bank account and you can then pay off other loans or credit cards with those funds.
Personal loans are a common type for debt consolidation. The loans are often unsecured, meaning a lender will approve you based on your credit background and you don’t have to put up collateral, like your car or home. However, a home equity loan, home equity line of credit, and cash-out refi are all secured (your home is the collateral) that you could use for debt consolidation if you have significant outstanding debt.
Using a balance transfer on a new credit card is another way to consolidate debt, but beware there are often fees to do a balance transfer, the new APR could be very high after one missed payment, and chances are you won’t be on a monthly fixed-payment installment plan.
Here’s an example of how a debt consolidation loan might help a borrower. Say you have $2,000 left on an auto loan with a 7% APR and four credit cards with a total balance of $6,000 and an average 22% APR. Each month, you pay $250 for the auto loan an $400 for the credit cards to cover the interest that accrues and a portion of your principal balances.
Suppose you could get approved for an $8,000 personal loan with a 6% APR. You could use the money to pay off the auto loan and credit cards. Now, you only have one monthly payment, saving you the time and hassle of managing multiple bills each month. Plus, your lower interest rate will save you money.
Depending on your loan’s term (how long you have to repay the loan), you might also have a lower monthly payment, freeing up room in your budget for other expenses or allowing you to pay off your loan sooner.
Some lenders may give you several loan options and let you pick your term. A longer term will lead to lower monthly payments, but it could also cost you more in interest overall. Or, you could choose a short repayment term with a higher monthly payment, forcing yourself to pay off the debt more quickly and paying less interest.
Even if you use an unsecured loan, consolidating your debts isn’t always the best idea, and you might wind up falling deeper into debt if you aren’t mindful.
Continuing with the scenario above, suppose you paid off your four credit cards with your debt consolidation loan. Now, you have four cards with $0 balances.
If you’re an impulsive spender or are facing a financial setback, you might start using your credit cards without being able to afford the full monthly payments.
If your original plan was to consolidate and pay off your debt more quickly, but now you’ve got your debt consolidation loan to repay plus new high-interest credit card balances. Ouch.
If you think you can manage a debt consolidation loan, look around at different lenders offering them and review their terms to find a good fit. Debt consolidation loans are available from online lenders, P2P lenders, traditional banks, and credit unions.
Start your search with a wide net, as you might not know ahead of time which lender will give you the best offer. Lender A might have the lowest advertised APR, but Lender B could be the one that offers you the lowest rate.
Narrow down your options based on a few criteria:
Look for online reviews and comparisons of lenders to learn about other borrowers’ experiences and see which lenders could be a good fit based on your creditworthiness. Also, be strategic about your applications.
Generally, lenders will review your credit reports when you apply and a “hard inquiry” gets added to your credit history. Hard inquiries stay on your credit reports for two years and impact many credit scores for up to a year. Each hard inquiry can lower your credit scores a little, and multiple inquiries in a short period may increase the negative impact.
However, some lenders can conditionally pre-approve you for a loan with a soft inquiry which won’t impact your credit scores. You’ll still have to submit an official application and agree to a hard pull before receiving an official offer, but trying to get pre-approved could help you weed out lenders that might not be good fits.
After getting pre-approvals and identifying potentially good lenders that don’t offer pre-approvals, submit official applications starting with the lender that you think is best.
Depending on the credit scoring model the lender uses, multiple hard inquiries that occur within a 14-day (sometimes up to a 45-day) window might only count as one hard inquiry for credit scoring purposes. Additionally, the scoring model may ignore inquiries from the previous 30 days. So, try to submit all your applications within a two- week period to limit the impact on your credit scores.
Once you accept a loan offer, many lenders can transfer the money directly to your checking account. You can then use the funds to pay off your current debt and focus on repaying your debt consolidation loan.
Louis DeNicola is a freelance personal finance writer and credit enthusiast. You can find him on Twitter @is_lou.