What Is Debt Consolidation?
Simply put, “debt consolidation” refers to the process of obtaining a new loan for the sole objective of paying off other loans and debts. Consolidating debt entails combining several smaller loans into one larger loan with more favorable terms of repayment, such as a lower interest rate or lower monthly payments, or both.
Paying off your debts can be made easier and more affordable by consolidating them into a single, more manageable payment plan. If you are able to negotiate a low-interest rate, you may be able to save a significant amount of money. If you consolidate your debt into a single payment, you’ll have a lot reduced chance of forgetting one and therefore ruining your credit.
How Does Debt Consolidation Work?
To reduce monthly payments, borrowers can apply for a personal loan, balance transfer credit card, or other consolidation option with their bank or another lender. Debt consolidation loans can involve either the lender paying off the borrower’s existing debts or the borrower taking the cash and using it to settle the bills themselves. In a similar vein, several credit card issuers offer their preferred method for cardholders to consolidate their existing cards and transfer their balances to a new card.
Types of Debt Consolidation
- Debt Consolidation Loan – Personal loans used for consolidating debt into a single, affordable monthly payment are known as debt consolidation loans. Most debt consolidation loans offer repayment durations of between one and ten years, and some even allow balances of up to fifty thousand dollars to be merged into a single monthly payment. The majority of loan providers do not place restrictions on the money’s intended usage. The borrower is responsible for using the loan profits to pay off the existing debts, such as credit card and loan amounts. Furthermore, you’ll start to make monthly payments to the bank or lender for the loan term.
- Balance Transfer Credit Card – If you carry balances on many credit cards, a balance transfer credit card may be a good option to reduce the overall interest you pay. Balance transfer credit cards work similarly to debt consolidation loans in that they allow you to consolidate numerous high-interest credit card balances onto a single credit card with a more manageable interest rate. There is normally an introductory term of 0% APR on balance transfers that lasts anywhere from 12 months to 21 months. You can save a ton of money on interest charges if you repay back the majority or all of your debts during the initial term. Nonetheless, if you still owe a lot of money after the promotional time ends, you can end up farther in debt because balance transfer credit cards often have higher rates of interest than other debt consolidation options.
- Home Equity Loan – With a home equity loan, often known as a second mortgage, you can borrow money against the value of your property. You can usually borrow up to 85% of your home’s worth (after subtracting your current mortgage balance), and the loan term can last anywhere from five to thirty years. Since the property serves as collateral, the interest rate on a home equity loan is typically much lower than that on a credit card or unsecured personal loan. However, if you fail to make your loan payments and a foreclosure sale is initiated, you will lose your home.
- Home Equity Line of Credit – Revolving lines of credit secured by one’s home are known as home equity lines of credit (HELOCs). Your HELOC interest rate is variable, like that of a credit card, and you can access the money whenever you need them. To borrow money with a HELOC, you have to consider how much equity you currently have in your property. Draw periods, or the time during which you can access your HELOC’s money, typically last 10 years. You can’t make any more withdrawals from your credit line until the repayment term ends.
- Student Loan Refinancing – Refinancing your student loans could be a possibility if you are paying an excessive interest rate. Refinancing student loans allows borrowers to consolidate multiple loans into one more manageable loan with a more manageable rate of interest and more advantageous repayment terms. You can save money by refinancing your student loans, but only if you qualify.
Debt Consolidation: Pros and Cons
It’s important to weigh the benefits and drawbacks of debt consolidation before making a final decision.
- Debt payback is simplified – Multiple credit card or loan payments might be difficult to track monthly, especially if they’re due on separate days. A debt consolidation loan simplifies monthly planning and payment tracking.
- Improve credit – Debt consolidation could improve your credit score. Credit card consolidation might reduce credit use. A debt consolidation loan could enhance your payment history.
- Less interest – If you can consolidate debts with a double-digit rate of interest into a single loan of around 10%, you could save hundreds.
- Increasing debt costs – How your debt consolidation loan is arranged affects your savings potential. With a similar rate of interest and longer payback period, you’ll pay more interest.
- Costs upfront – Any debt consolidation may have origination, balance transfer, or closure fees. Before applying, compare fees against potential savings.
- At-risk collateral – If you employ a secured loan to safeguard your debt, like a home equity loan or HELOC, the collateral is liable to seizure.
Debt Consolidation vs. Debt Settlement: What’s the Difference?
There are fundamental differences between debt consolidation and debt settlement. Debt settlement entails engaging and financing a third-party company to arrange a lump-sum payment that creditors will take in lieu of the full balance. These settlement companies charge 15% to 20% of the debt and are often scams.
In debt consolidation, the borrower pays off all debt with a new loan. Unless there are the origination or administrative fees, borrowers don’t pay to consolidate. Debt consolidation encourages consumers to inventory their obligations and design a strategy to repay them back in a more simplified, typically less expensive method.
Is Debt Consolidation a Good Idea?
Debt consolidation is usually an excellent idea if you have a high credit score and are making other efforts to enhance your financial habits. A debt consolidation program could be beneficial if:
- Under the terms of a consolidated loan, you are obligated to pay back the full loan balance.
- You can comfortably make all of your loan payments from your cash flow.
- You don’t mind extending the term of your loans or are willing to pay them off early.
- A better interest rate may be available to you now because your credit has developed since you first took out loans.
- You’ve created a strategy to keep from accumulating new debt.
On the other hand, you shouldn’t pursue debt consolidation if:
- You are not prepared to take further measures to settle your financial obligations.
- You have no strategy to prevent incurring further debt.
- Due to the short time, it would take you to repay your debt, any savings from debt consolidation would be minimal.
When Does Debt Consolidation Make Sense?
When your combined interest rate on all your obligations is lower than the interest rates on your individual debts, consolidation makes financial sense. The result is reduced monthly costs. In turn, you can utilize the extra cash to make more substantial payments, increase your savings, or broaden your investment horizons. One of the psychological benefits of debt consolidation is the convenience of having only one monthly payment to worry about, rather than several.
Prior to deciding to consolidate your debt, you should examine why you have so much debt. Debt consolidation is a good option if you’ve established some financial stability but still have outstanding debt from a previous period. Don’t rush into anything; instead, look into your options and compare rates from many lenders, such as local credit unions, online banks, and others. Find the best deal possible by weighing the interest rates, fees, and terms offered by various lenders.