Back in my banking days, with the exception of mortgages, personal loans were the go-to mainstay of lending. Our promotional material stated, “we can give you a loan for any worthwhile purpose – vacation, wedding, appliances, new car.” (Please, don’t shoot this messenger – that’s the way it was.)
One of the most common reasons for getting a personal loan was to consolidate multiple debts.
With the advent of lines of credit and home equity secured lines of credit, personal loans – especially consolidation loans – are not that popular today. But, if you find yourself with multiple outstanding credit card balances and smaller loans you’re having a hard time paying each month, why not consider a consolidation loan which will convert your many debts into one more manageable payment?
How does a personal loan work?
A personal loan is installment credit rather than revolving credit (as in credit cards and lines of credit).
You borrow a lump sum of money at a fixed rate of interest which you pay back gradually by making equal payments over a set period of time.
The payments you make are a combination of interest and principal which will gradually reduce the amount you owe until the loan is fully paid off. You know in advance exactly how long it will take to repay the loan and exactly how much it will cost you.
Once you repay the loan it’s done – It doesn’t replenish itself when you make a payment like a line of credit does.
Unsecured consolidation loans have never been very common. If you have assets – car, non-registered stocks or bonds, or a GIC – to secure the loan you will get a much lower rate of interest.
Advantages of a consolidation loan
1. You will save money on interest charges. Considering that the average credit card interest rate is around 19.9%, a term loan charging half that rate will save you hundreds (or thousands) of dollars, helping you get out of debt faster.
2. You know exactly when you will be debt free. Don’t we all like knowing when we’ll reach our goals?
3. One fixed monthly payment to manage. That’s a lot simpler than having many payments and due dates.
4. Protect your credit rating.
Disadvantages of a consolidation loan
When a customer wanted to consolidate multiple debts, I confiscated and cancelled all (except maybe one) of their credit cards. Invariably, (once I was out of sight) more than half would reapply for new credit cards and ramp up their overdraft protection, spending their way into a new debt cycle and getting into the same situation as before.
Related: Debt avalanche vs. debt snowball
This type of loan will not work for you if you don’t change and control your spending habits. It will just put you on the consolidation loan treadmill, extending the terms longer and longer.
If you must borrow (for a worthwhile purpose?) a good way to go is using an installment loan with a reasonable rate of interest. The larger the payment amount, the shorter the term, and the sooner the loan will be paid off.
A consolidation loan will pay off all your smaller balances. Payments that fit your budget will save you money and eliminate your debt much more quickly.