You hear a lot of rubbish online about getting a debt consolidation loan and a lot of just flat out incorrect information. It’s time to put an end to that and help you get the facts so you can make a good educated decision.
If You Don’t Want to Read All of This Post: One consideration would be to apply at the same time for both Lending Club and SoFi and see who gives you the lowest rate. Hey, it’s all about the math, right?
So here is my guide to help you learn the pros and cons about getting a debt consolidation loan successfully, learning what to avoid and how to minimize your risks in borrowing money to consolidate your debt.
If you are serious about getting a debt consolidation loan then you’ll have to put in the time to wade through all this information. So get comfortable, here we go to understand debt consolidation loans, learn the pros and cons, and get in shape to get approved for one.
Types of Debt Consolidation Loans
There are a number of loans that people use for debt consolidation, let’s review those first.
Advance Fee Loans
You will come across ads that promise a debt consolidation loan if you pay a fee in advance. Sometimes this fee is called an insurance fee or processing fee. It is really just a scam fee to rob you of money and never give you the loan.
The tip-offs are that the bogus lender will ask you to pay the fee via Western Union, MoneyGram or buy a prepaid card. If they do, run away, fast!
In all my years I’ve never seen one of the loans ever come through.
IRA, 401(k), or 403(b) Retirement Fund Loans for Debt Consolidation
I’m generally not a fan of these types of loans. For the most part, they rob you of your future retirement by causing you to lose out on building wealth and they can accidentally be taxable if you change jobs or can’t pay back the loan.
A good article on this subject is Here’s Why a 401(k) Loan to Pay Off Debt Can Cost You a Massive Amount in Retirement.
After knowing the financial impact and potential big future losses you may decide to take out one of these loans to consolidate debt. Seek professional advice before doing so and think twice.
Home Equity Lines of Credit, HELOC, Cash Out Mortgage Refinance
Using your house as an ATM is possible if you have equity to borrow against and a good credit score. Again, this may be an easy type of loan to get but it has a huge risk. Since the loan is going to be secured by your house, if you are unable to repay your loan for any reason it can lead to the loss of your home if you default. Additionally, the new bigger loan will increase your house payments and if you accidentally get into debt again it will create greater pressure in your budget.
Borrowing using your home as collateral may be at a lower interest rate but that rate comes at a cost to you. Consider the interest rate reduction to be your bet that everything will work out perfectly in the future until you repay the secured loan. That gamble has a cost and that cost is the lower interest rate.
For now, the interest you pay may be tax-deductible with these types of loans but it might not be that way in a few years and Congress is talking about ending that deduction. We’ll just have to wait and see.
Title Loans, Payday Loans, Finance Companies
Don’t do it. These high-risk loans often lead to much bigger problems. If you have to turn to one of these lenders you should first consider bankruptcy to get a legal fresh start and second chance.
You can click here to find a local bankruptcy attorney and talk to them for free about your specific situation. Get the facts and then you can make an informed and educated decision if bankruptcy is right for you.
Unsecured Debt Consolidation Loan – Generally the Best
An unsecured debt consolidation loan is one where you borrow money using your credit score and financial details alone. It does not require you to risk any collateral or face any tax liability.
While it is tougher to get an unsecured debt consolidation loan out on Main Street it is possible from peer-to-peer lenders like Lending Club and SoFi. These organizations are registered and organized to extend loans across most of the country. They allow people like you and me to help fund the loan requests of others like you and me.
Essentially peer-to-peer lenders cut the banks out of the loop and allow people getting loans to get lower rates.
The majority of these loans are for debt consolidation so they regularly deal with these types of requests.
While the interest rate on an unsecured debt consolidation loan is higher, there is no risk of losing your home if you default. If you do find yourself in unexpected bad times you can always file bankruptcy and include the remaining loan in your bankruptcy. There is also no risk of lost retirement returns from draining your retirement accounts or potential tax bills. This is why I feel these are generally the best type of debt consolidation loans to go for.
There are two groups, Lending Club and SoFi, who both pay this site a referral fee and do a good job of issuing loans to readers.
Debt Consolidation Loan Pros and Cons
Debt Consolidation Loan Pros
The right debt consolidation loan has some advantages:
- It can reduce your consolidated debt faster if the interest rate is lower than that of your aggregated debt. But that’s just math in action.
- A good payment history on your loan can help to boost or maintain your good credit score if the lender reports to the three major credit bureaus. Many local banks do not. Nobody suffers from having better credit.
- If can lower your monthly payment it can give you some breathing room in your budget each month. Money you can use to save for retirement so you don’t have to live on food stamps when you get old.
Debt Consolidation Loan Cons
The wrong use of a debt consolidation loan can be a disaster:
- Secured loans put the collateral at risk. Your call.
- Loans from retirement funds lower your retirement returns and have risks of taxes due or acceleration. If you like earning less and paying more taxes, go for it.
- If you consolidate your debt and run the credit cards back up you will be in deeper debt overall with a consolidation payment and new credit card debt. Dumb.
Some debt relief companies are sending out mailers claiming you have been pre-approved for a debt consolidation loan. These mailers appear to be nothing more than a bait and switch tool to get you to call, hoping you will get the loan, and then say you don’t qualify. The salespeople then sell you into a debt settlement program.
How to Get in Shape to Successfully Apply for a Debt Consolidation Loan
If you have decided a debt consolidation loan is right for you and you want to take a shot at applying for one, let’s get you in financial shape to get approved.
Step 1 – Get Credit Report
I recommend you get a consolidated credit report. This will merge the information from all three major credit bureaus into one easy to read report. In my opinion, this format makes it the easiest to spot errors and mistakes when comparing what each of the credit bureaus says about you.
If you want to make it harder on yourself then you can get individual free credit reports from AnnualCreditReport.com and do your best to compare them. Yea, it’s free but harder to spot the inconsistencies. It will not contain your credit scores.
Step 2 – Review Credit Report
Once you have your consolidated credit report in front of you I want you to look at the reports and circle any information that may be erroneous, incorrect, or not belong to you. Use a highlighter.
You should follow the dispute process for each credit bureau as instructed in the consolidated report.
If you found information that is reported wrong, you should wait for the credit bureaus to make those corrections before applying for your debt consolidation loan. They will send you a notification when the fix has been made.
The consolidated credit report will also contain your three different credit scores from each bureau. They will be different. Each credit bureau tweaks it a bit so they can be “special.”
The consolidated credit report will give you information about why your credit score is what it is. Some actions to improve your score may be possible for you to implement before you apply. Do it.
Step 3 – Gather Data
Before you apply you are going to need to gather important financial data to use for the application. Gather a few of your last pay stubs, last years tax return, statements about your debt, and information about your monthly income and expenses.
Step 4 – Apply
If you have followed the above three steps you will be in better shape to apply for a debt consolidation loan by a secured lender or unsecured lender.
As a reminder, for unsecured debt consolidation loans, I personally recommend Lending Club or SoFi as the lender of choice for most people and most situations.
You will stand a chance of getting approved for an unsecured debt consolidation loan if your credit score is 660 and above.
Lending Club says those most likely to get approved will meet the following criteria.
- You must be a US citizen or permanent resident and at least 18 years old with a valid bank account, a valid social security number and a FICO score of at least 660.
- You will need a debt-to-income ratio (excluding mortgage) below 35%. In addition, your credit history must show that you are a responsible borrower:
- You must have 2 or more revolving accounts
- You must have more than 36 months of credit history
- You must have less than 7 credit inquiries in the last 6 months – Source
One consideration would be to apply at the same time for both Lending Club and SoFi and see who gives you the lowest rate. Hey, it’s all about the math, right?
The downside to this strategy is it will result in two credit inquiries on your credit report. The upside is it can help you find a lower rate. According to FICO, the credit score people, the additional inquiry would result in about a five-point hit.
It’s your call.
If you do apply with both, please post a comment below and let me know who gave you the lower rate it would be nice to be able to share that information with readers.
Step 5 – Evaluate and Consider
After you apply for your debt consolidation loan you will hear back if you were approved and what the interest rate will be based on your credit score and lending risk. Essentially that’s all a credit score is anyway, an estimation of the amount of risk a lender will have to accept when they make a loan to you. The higher the score, the lower the risk. The lower the risk, the lower the interest rate will be.
Being approved is an awesome feeling but before you leap and say yes, it’s time to consider what your monthly payment will be and if you can actually afford it.
Remember, no lender extends credit because you can afford it. They extend credit because they are willing to take the risk.
Only you can decide if the approved loan is going to be both affordable and appropriate for you.
One way to determine if the loan is affordable is to make sure the monthly payment will be significantly less than the payments for the debt you are paying off with the loan.
Step 6 – After you Payoff Your Consolidated Debt
If you have paid off credit cards with your new debt consolidation loan, don’t make the rookie mistake of closing your major credit cards. Close all the store cards you want but leave open any Visa, MasterCard, American Express or Discover accounts you pay off.
“But Steve that’s stupid!”
Yea, stupid smart. You see the length of your ongoing credit history is a big part of a good credit score. If you close those accounts you kill that benefit.
Just don’t run up the balances on the cards. Keep them locked away in a drawer or do whatever you want to with them but don’t close them. You can have credit without having debt.
Used wisely a debt consolidation loan can be a smart thing to do, but getting the right one, that’s the even smarter bit.
Just remember, debt consolidation loans don’t run up debt, people run up debt.
Be safe and practice safe debt.
And before you go, if you found this guide helpful, please leave a testimonial below.