Should I Consider Loan Consolidation?

loan-app.jpg
••• Nick M. Do/E+/Getty Images

If you have a large amount of debt, loan consolidation may be your answer.

Loan consolidation is when you use one larger loan to pay off several small loans, usually to get a lower interest rate or monthly payment.

There are two types of loan consolidation, secured and unsecured. A secured loan requires some sort of collateral, such as your home, while an unsecured loan requires no collateral but are harder to get. You'll typically need a high credit score to get an unsecured loan. That's why loan consolidation can be risky. But it still may be the right option for you.

What About Student Loan Consolidation? 

One common type of loan consolidation is student loan consolidation. This type of loan consolidation is usually beneficial because you lock in a lower interest rate on the student loans.

You also have the option of extending the life of the loan, and thereby lowering the monthly payments. If you choose to do this it is important to realize that it will increase the amount of interest that you pay because you will be paying on the loan longer. However, that may be worth having more manageable payments, and you can increase your payments as your income increases.

If you do decide to consolidate your federal student loans, it's wise to do so via the federal government, rather than with a private loan servicer. Here's why: If you consolidate with a private loan, you'll lose consumer protections associated with federal loans, and you won't be eligible for student loan debt forgiveness programs. 

Can I Consolidate Other Types of Loans?

You can also consolidate your credit cards, your car loans or signature loans. You will just need to take out a larger loan and use that money to pay off your other debts. Before you consolidate credit card loans, car loans, or any other type of private loans, be sure that you will actually end up saving money in the long run.

Many banks will specialize in consolidation loans, and you may get loan offers in the mail that offer consolidation loans at low rates. If you receive these, read the fine print and look for reviews online since many of the interest rates are ranges, not guarantees. You should also research the company before signing on the dotted line.

What Are the Risks of Loan Consolidation?

A few things to keep in mind before you consolidate your loans. First, know the difference between an unsecured loan and a secured loan. The latter is riskier because it is tied to a larger asset, (like your car or home), so you risk losing that property if you default on the loan.

Second, you should always consider the lower monthly payment of a potential loan consolidation versus the interest rate. Be sure that loan consolidation is the most financially beneficial option for you, and don't just do it because it's easier to have only one big payment a month.

There's also the risk that loan consolidation won't actually help you get out of debt. Loan consolidation will often free up a little bit of extra income, and pay off some credit card balances. However, this does not mean that you should continue to spend money at the same rate that you were previous to the consolidation. It's important to look at your financial behaviors carefully before you take this step.

What Are the Benefits of Loan Consolidation? 

Many people consider doing loan consolidation because it allows them to lock in the loans at a lower interest rate and gives them a set payment. It is important to consider how much lower the interest rate is and whether or not it is a permanent rate before you take this step.

While loan consolidation can be a smart move, it's only beneficial long-term if you stop using your credit cards or change your habits so you do not continue to run up debt. You also need to choose a good consolidation loan with solid terms and a set interest rate.

Will Loan Consolidation Fix My Debt Problems?

Most importantly, loan consolidation does not address the spending habits that got you into debt into the first place. It is important to address those problems and stick to a budget in order to change your financial situation, whether you decide to pursue a loan consolidation or not.

You need to address the real issues in your spending habits in order to get ahead financially. The first step is to get on a budget so that you can stop overspending. Only then will you be able to start working toward your financial goals. 

Updated by Rachel Morgan Cautero.