A debt consolidation loan is a single large loan designed to replace several smaller debts. Under certain circumstances, a debt consolidation loan can make it easier to pay off debt in less time and with less interest. However, some financial counselors disagree that debt consolidation loans are a good idea.
Structured Consolidation
Some types of debt allow for structured consolidation. For example, many student loan lenders, including the federal government and state agencies that administer federal student loans, allow student loan borrowers to group their multiple student loans into a single consolidated loan payment. Private lenders also offer student consolidation loans. Additionally, federal bankruptcy law allows a debtor to file Chapter 13 bankruptcy to create a debt consolidation and repayment plan that lasts for three or five years. The debtor makes a single monthly payment to the bankruptcy court, and then the bankruptcy trustee pays out a portion of the payment to each of the debtor's various creditors.
Advantages
Debt consolidation loans can provide several advantages to a borrower. Home equity loans, for example, typically carry a lower interest rate then credit cards or installment loans. Additionally, consolidation reduces administrative headaches. Instead of making several payments to several creditors each month, you make a single payment. This can make it easier to track your progress over time and to eventually pay off your debt, especially if you're paying less total interest. With a Chapter 13 consolidated repayment plan, you may be able to repay your debt in full by paying less than the amount you owe. For those reasons, a debt consolidation loan can make it easier and quicker to get out of debt.
Disadvantages
Some financial advisers, such as nationally recognized talk show host and financial adviser Dave Ramsey, do not recommend debt consolidation loans. Dave Ramsey instead recommends a debt snowball approach. Ramsey suggests that paying off your smaller debts first can give you optimism and momentum to continue paying off other debts. In that sense, although a consolidation loan may save you a little money, its benefits may not outweigh the fact that you don't build momentum over time as you pay off smaller debts. Consolidation loans don't allow for the "feel good" factor of paying off each individual debt.
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