Borrowing to pay off debt, often called debt consolidation or refinance can be a useful strategy if, the consolidated loan offers a lower interest rate, a simplified payment option, and the chance of improving the credit score.
But, why would someone need a loan to pay off a previous loan?
The answer is simple. If the borrower is struggling to make multiple monthly payments on different dates, refinancing the existing loans becomes one single monthly payment and potentially with a lower interest rate.
Key Takeaways
- Consolidation refers to combining multiple debts into a single loan
- Refinancing is beneficial if the new loan offers lower interest and flexible payment term
- Consolidation temporarily decreases credit scores but again improves in the future
- It requires a healthy DTI, preferably below 36%
- Lenders offer refinancing to acquire more clients as a business strategy
What are the benefits of consolidating or refinancing?
Consolidating multiple loans offers a few advantages such as lower interest rates, smaller size of monthly payments, chances of reshaping loan portfolio, and the possibility to maximize the credit score.
If you can get a loan with a lower interest rate than your current debt, it can save you money on interest payments. That’s how the refinancing strategy works.
Similarly, when you convert the existing loans to a single one, the new lender can offer you extended terms that make your monthly payment smaller than the earlier.
Furthermore, handling multiple loans increases the risk of missing out on timely payments which creates a negative impression on credit scores and brings penal interests. Surely, consolidating addresses this issue if you can make future payments on time.
What are the disadvantages of refinancing?
Consolidation or refinancing will introduce additional fees, increase your overall debt size, and account for more interest for the longer payment terms.
New loans might come with fees, such as origination fees, balance transfer fees, or early repayment penalties from your existing debts. For example, while consolidating, a borrower needs to pay 1% to 3% as origination fees that are deducted from the new balance. Similarly, a 3% to 5% balance transfer fee is also applied to the refinancing.
There is also a risk of accumulating more debt if you don’t address the underlying spending habits that led to the debt. As a result, you might end up accumulating more loans on top of the new loan. For instance, consolidation will have an interest of typically between 5% to 36%, depending on creditworthiness and loan type. The amount can also get large in the future and the borrower may not find another option to refinance again.
Sometimes, consolidating debt can extend the repayment period, which might mean you pay more in interest over the long term, even if the monthly payments are lower. Initially, the proposal seems acceptable because the refinanced loan will offer lesser interest than what you pay now. However, extending the loan terms would cost you additional interest over the extended period.
When will you consider taking a new loan to pay off the earlier debts?
In short, borrowing again to repay the older loans can only help you if it offers the possibility to maximize your credit score by reducing loan amount and cost and making timely payments.
Such a strategy only works if you can prove saving money. For example, someone with higher credit card balances would definitely need a refinancing option. As of 2023, the average interest rate for a 24-month personal loan is 9.41%, compared to an average credit card interest rate of 19.24%, which proves that a personal loan (be it a consolidation) is always cheaper than credit cards.
Per the FICO, your score will be decreased by 5% to 10% while consolidating. But, making future payments timely can increase the score significantly.
You can also consider consolidating loans if any lender offers you promotional interest rates for balance transfers or new loans. If you qualify for a 0% or low-interest introductory rate, it could help you pay off your debt more quickly and with less interest.
Another consideration could be an improved Debt to Income Ratio. Ensure that the new loan improves your debt-to-income ratio, which can impact your financial stability.
Lastly, make sure the APR of the new loan is cheaper than the earlier one. It will help improve your DTI over time.
However, before considering the consolidation or a refinance, look into other debt management strategies, such as negotiating with creditors, setting up a debt management plan, or seeking financial counseling.
When borrowing to pay of earlier loan is harmful?
Avoid borrowing if the new loan terms are not favorable, such as high interest rates or excessive fees.
If you have not addressed the reason for your debt, a new borrowing cannot be beneficial as you are always exposed to larger debt due to not rectifying the budget gaps.
Lastly, borrowing to pay off debt is not a solution for short-term cash flow problems. It requires a long-term commitment to paying off the new loan. For example, consolidation cannot solve your large credit card balance with a 26% APR. Rather, you can apply a loan avalanche strategy to pay off a high APR loan with savings made by following a financial plan.
How can you maximize your chance of getting a new loan?
A lender will allow you a refinancing proposal based on your credit score, DTI, and completeness of the documentation. Sometimes, a borrower with less creditworthiness requires a co-signer to secure a new debt.
Here are tips to maximize your chances of getting accepted for a new loan:
- Pay bills on time, reduce credit card balances, and avoid opening new credit accounts before applying. It will improve your credit score.
- Pay down existing debt and avoid taking on new debt. to reduce your DTI ratio.
- Ensure all required documents, such as proof of income, identification, and credit history, are accurate and up-to-date.
- Compare offers from multiple lenders to find the best terms and improve your chances of approval.
- If your creditworthiness is a concern, a co-signer with good credit can improve your chances of approval.
Why do lenders offer consolidation or a refinance?
It may sound crazy but why would a lender offer you a new debt to pay off your existing loans?
Lenders offer refinancing that gives them a chance to earn more interest, mitigate risk, manage their portfolio, help acquire customers, and business sustainability.
Total consumer debt in the U.S. reached $14.96 trillion in 2021, with credit card debt alone accounting for approximately $784 billion. According to a LendingTree study, 68% of personal loan borrowers in 2021 used the funds for debt consolidation.
It means lenders help the borrowers to pay off loans and carry another loan in a win-win situation.
Lenders earn interest on the new loan, which can be a steady source of revenue. For instance, a refinancing may offer you a 0% balance transfer fee but asks for an interest for an additional three years.
By simplifying the borrower’s payments and often reducing their monthly obligations, the risk of missed payments or default decreases, lender mitigates the borrower’s risk and engages that borrower for the next five years.
Moreover, offering debt consolidation helps bring new clients that are a part of market penetration. Indirectly, one lender snatches another lender’s client with lucrative offers and commitments.
Also, consolidating multiple high-risk debts into a single, lower-risk loan can improve the quality of the lender’s loan portfolio. Such portfolio shuffling decreases lenders’ overall cost of managing clients. Additionally, keeping clients with better credit performance reduces the BASEL liquidity requirement for the lender.
Who offers debt consolidation?
Banks, credit unions, online lenders, credit card card companies, debt management companies, and peer-to-peer lending companies offer refinancing options as they gives the lenders additional source of income with greater customer portfolios.
Taking loans from banks and credit unions can offer competitive interest rates, especially if you have an existing relationship with the institution.
Online lenders are also popular for refinancing mainly due to the convenient application process, quick approval, and a wide range of options.
Credit card companies also offer services such as balance transfer credit cards with promotional low-interest or 0% APR for a certain period. Such offers are beneficial if the balance is paid off within the promotional period.
Debt management companies help to consolidate debts into a single monthly payment plan, often with reduced interest rates through negotiation with creditors. Usually, borrowers with the inability to manage loans engage such debt management companies.
Peer-to-peer lending platforms also have debt consolidation services but on a smaller scale. In a P2P platform, a borrower gets engaged with someone with money who can help refinance the borrower’s existing debt but, the offer may not be suitable like banks.
How does credit score change with loan consolidation?
Firstly, taking a refinancing option would generate an additional hard query that reduces the credit score for a while. (usually, a 5-10 points decrease is noticed per the FICO data).
However, data shows that borrowers who consolidate their debt see an average credit score increase of 20 points within three months of taking out the loan, provided they make timely payments.
Moreover, refinancing makes the monthly payment smaller which helps the borrower to make timely payment,s and creates additional savings. Credit score also gets improved by this way.
Notably, the average minimum credit score needed to qualify for a personal loan for debt consolidation is around 640. However, better interest rates are available for those with scores above 700.
What additional documents do you need to consolidate loans?
Besides the mandatory documents, a borrower also needs a debt payment plan supported by the earning summary. The new lender would also ask for the statement and balance certificate of each loan during the screening process.
If the borrower is pledging an asset as a security of the consolidated loan, the lender needs documents related to the collateral (e.g., property appraisal, deed, insurance).
What are the alternatives to debt consolidation?
For individuals seeking alternatives to debt consolidation, options such as the debt snowball method, debt avalanche method, balance transfer, and debt management plans provide viable solutions.
The debt snowball method focuses on paying off the smallest debts first to gain momentum, while the debt avalanche method targets high-interest debts to minimize total interest paid. For example, if Jane has multiple credit card debts, she might use the debt snowball method to quickly eliminate her smallest debt, boosting her confidence to tackle larger ones.
Another alternative is a balance transfer, where high-interest credit card balances are moved to a new card with a 0% introductory APR, allowing more payments to go toward the principal. This strategy works well for someone like John, who has several high-interest cards and can pay off the balance within the promotional period.
Similarly, debt management plans involve working with a credit counseling agency to negotiate lower interest rates and create a structured repayment plan, suitable for those needing professional help to manage their debts.
In case you are completely unable to repay your debt, try taking the help of debt relief providers. Debt relief companies will help you with debt settlement, debt management plan,s and bankruptcy filing.
What is the required DTI for debt refinancing?
Typically, lenders prefer a DTI ratio of 36% or less. However, borrowers with a DTI of up to 43% are eligible for consolidation, but the higher DTI would make the interest rise.
We noticed that ratios above 43% are often viewed as risky by conventional lenders, which may lead to denial or the need for non-traditional refinancing options.
However, for government-backed loans, a DTI threshold is flexible. Lenders allow a maximum DTI of 57% for FHA loans and 60% for VA loans in some cases. Similarly, refinancing a USDA loan will have a DTI tolerance level of a maximum of 41%.
If you are worried about your DTI ratio, try our calculator to get yours.
Should you consolidate bad debts?
Bad debts are loans that do not significantly contribute to the borrower’s economic stability and wealth creation. This is always better to repay the bad loans first if the amounts are easily repayable.
However, if you have too many bad debts that make your money management tougher, you can consider consolidating them. But, keep in mind that the consolidated loans would again create additional interest even if the monthly payment becomes simpler.
Bottom Line
Loan consolidation or refinancing the existing debt can be an effective debt management strategy for those looking to streamline their debt repayments and potentially lower their interest rates. By merging multiple high-interest debts into a single, manageable loan, borrowers can simplify their financial lives and often save money in the long term.
However, it is crucial to thoroughly evaluate your financial situation considering all the aspects of deb management, understand the terms and costs associated with consolidation, and ensure that the new loan is truly beneficial. If needed, take professional helo from us.
Good luck
