A recent study by a financial institution showed that 39.2% of their borrowers use personal loans for consolidating their debt. Perhaps you have several payday loans and installment loans, and you can’t easily manage the payments. This may be due to high interest rates or high payments beyond what you can manage on your budget.
Debt consolidation may help you get lower interest rates and/ or lower payments. This guide explains how consolidation works for payday and installment loans.
What is Loan Consolidation?
Understanding what loan consolidation is can help you figure out how to apply it to payday and installment loans. Debt consolidation allows you to pay off multiple loans, often from different lenders, using money from one new loan. This way, you simplify your existing debt by making one monthly payment instead of having to keep up with multiple loans.
One objective of loan consolidation is to get a lower interest rate, so you have a lower total cost for the life of your loan. For instance, a $100,000, ten-year loan at an interest rate of 9% will have monthly payments of $1,266.76, and the total interest paid will be $52,010.93. In comparison, a $100,000, ten-year loan at an interest rate of 4.5% will have lower monthly payments of $1,036.38, and the total interest paid will be $24,366.09.
You may also use a longer-term debt consolidation loan to have lower, more manageable monthly payments, even if that means having a higher total interest payment at the end of the loan term.
For instance, a $100,000 ten-year loan at an interest rate of 4.5% will have monthly payments of $1,036.38, and the total interest paid will be $24,366.09. In comparison, a $100,000 20-year loan at an interest of 4.5% will have lower monthly payments worth $632.65, and the total interest paid will be $51,835.85.
Debt consolidation can be used for multiple types of loans, including payday and installment loans.
Why Consolidate Payday Loans and Installment Loans?
There are various legitimate reasons why you may want to consolidate payday and installment loans. The reason you want to consolidate may also influence how you consolidate the loans.
Debt consolidation may be an option if managing monthly payments on your current debt obligations is challenging. This may apply particularly to borrowers facing delinquency issues (delayed payments on loans that are past the due date). For instance, unsecured personal loans (a form of installment loan) have a 3.31% delinquency rate, and payday loans generally have a 6% default rate.
Perhaps your credit score was low when you took out the payday and installment loans. Thereafter, it improved while you continued paying your loans. This means that you might now qualify for a better interest rate or better loan offers. As a result, refinancing to take advantage of these new terms may be a favorable option.
Loan consolidation might also be a good option if the blended interest rate (the combined interest rate) on all your debts is higher than what you can get from a debt consolidation loan. The average interest rate for personal loans range from 10% to 28%; whereas, payday loans typically have a 400% APR (the annual percentage rate, which includes the interest rate and all fees).
Consolidating Payday and Installment Loans Using Balance Transfer Credit Cards
If your main reason for seeking debt consolidation is to take advantage of lower interest rates, then a balance transfer credit card may be a good option. A balance transfer card simply allows you to transfer your existing credit card balance (credit card debt) to the balance transfer credit card. Some credit card issuers also allow you to transfer an existing loan to the balance transfer card.
You benefit from this type of transaction because balance transfer credit cards usually have a promotional 0% APR for a set amount of time. The promotional rate often lasts for a period of roughly 12 to 20 months. This way, you can pay off your debt without interest during the introductory period.
In general, consolidating payday and installment loans is beneficial if the combined amount of debt you’re transferring is lower than your credit limit. Also, consider the transfer fees, the APR for new purchases on the credit card, and the APR when the promotional rate ends, in case you take longer to repay your debt. Also read the card’s fine print and be sure you understand all of the terms.
Consolidating Payday and Installment Loans Using Debt Consolidation Loans
Another option is a debt consolidation loan that has a lower APR or lower monthly payments than your current loans. A lower APR can reduce the total dollar amount you owe in interest, and lower monthly payments can help you comfortably manage your payments.
However, you may need to consider the terms of the loans you’re paying off. Perhaps, they may have an early repayment fee that you should consider in calculating the cost of consolidating your debt. Most importantly, lenders will likely require a good credit score when you apply for a low-interest debt consolidation loan.
Consolidating Payday and Installment Loans using Debt Management Plans
A debt management plan is another option that may help you negotiate lower interest rates on your loans and simplify your payments.
A debt management plan (DMP) is available through nonprofit credit counseling agencies. This program is designed to help borrowers who are struggling with large amounts of unsecured debt. It is not designed to help address student loans.
A DMP follows these key steps:
- You’ll discuss your financial situation with a credit counselor and determine if a DMP is a good choice for you.
- If you opt for the DMP, the counselor contacts your creditors and negotiates lower interest rates, fees, monthly payments, or all of the above.
- The credit counselor becomes the payor on your accounts.
- When your creditors reach an agreement with your counselor, you’ll make payments to the credit counseling agency, which in turn, pays your creditors.
Borrowing From Home Equity or Retirement Accounts
Consolidating your loans by borrowing against your house or from your retirement account may have a potential risk to your assets and your credit score.
To borrow against your house, you may use a home equity loan (a loan secured by your home) or a HELOC (a home equity line of credit, which offers an amount of credit from which you can draw). These options typically offer lower interest rates compared to unsecured loans because your home serves as collateral for the loan.
Alternatively, you can get a maximum of $50,000 or up to 50% of your retirement funds, when borrowing from your 401(k). The advantage here is that the interest rate is typically low, it doesn’t require a credit check, and repayment is deducted from your paycheck.
When you pull out funds from your 401(k), they lose the power of compounding interest. Furthermore, if you don’t repay the full amount, you may face an early withdrawal penalty and income taxes on the amount withdrawn. Therefore, most people should probably only consider this option after exhausting other alternatives or in a financial emergency.
Debt Consolidation vs. Other Methods of Handling debt
Debt consolidation may have various advantages and disadvantages compared to the other methods of handling outstanding debt. Understanding the unique benefits and risks in each method can help you figure out if debt consolidation is the right choice.
The Debt Snowball
The debt snowball method is another way of dealing with debt, based on the concept of a snowball rolling down a hill and gaining speed and size as it goes along. It works by paying off the smallest debts first and working your way up to the largest. You make the minimum payments on all other bills and send all the extra cash to the smallest bill until it’s gone.
Compared to debt consolidation, the debt snowball doesn’t help you reduce your monthly payments or interest rates.
The Debt Avalanche
With a debt avalanche method, you make the minimum payments on lower-interest debt, while focusing on paying off the highest-interest debt first. This may help you reduce the total interest payments on your highest-interest debt, since you may be able to repay the loan early.
Unlike the debt avalanche method, debt consolidation may help reduce the interest rate of your highest-interest debt.
Another method of handling debt is called debt settlement. This is different from a debt management plan (a debt consolidation strategy) since it’s about negotiating a payment with your creditor that’s lower than your full outstanding balance. If you work with a debt settlement company, your new negotiated amount may come down to 80% or even 50% of your total balance.
Unlike debt consolidation, you may have to pay taxes on the forgiven debt in debt settlement since it may be reported as income to the IRS. Since debt settlement negotiations can take a long time, it may be better suited to accounts that are severely delinquent or in collections. Moreover, the settled debt will be marked as “paid settled” on your credit report and will remain there for seven years.
Debt Consolidation and Your Credit Score
A good debt consolidation plan can boost your credit score in the long run. However, in the beginning, your credit score may drop. The debt consolidation method you use will affect how long it takes your score to recover.
When you apply for the new debt consolidation loan, the lender will likely make a hard inquiry on your credit report. This may lower your score by a few points, but it tends to recover fairly quickly. Adding a new debt consolidation account may reduce the average age of your credit accounts, which can also reduce your credit score.
A high credit utilization (the percentage of available credit that you use) on your new debt consolidation account may negatively impact your credit score. The score is likely to improve as you pay off your debt and avoid incurring new debt.
With a debt management plan, you may also be required to close your credit cards, which can have a negative effect on your credit score. That’s because your report will show less available credit. Fortunately, your score will likely recover as you follow the debt management plan.