What Is Debt Consolidation? When Is It A Good Idea?
Debt consolidation is an option for those who have multiple debts. People might consolidate their debt for several reasons.
These might include simplifying their finances, securing better interest rates, or decreasing their time to pay off debts.
We’ll explore what it is, how people consolidate their debt, and the potential benefits and drawbacks.
What Is Debt Consolidation?
Debt consolidation is the process of taking multiple debts and paying them off with another financial product, so you only have a single debt.
The Consumer Finance Protection Bureau describes debt consolidation as when:
“various debts–whether credit card bills or other loan payments–are rolled into one loan or monthly payment.”
Consolidating debts can help borrowers simplify their finances and get out of debt sooner in certain situations. These debts might be personal loans, credit cards, student loans, or others.
How Does Debt Consolidation Work?
Once the person in question has applied for and received a debt consolidation product, they can begin making payments to pay off the balances on their existing loans.
After the borrower pays in full all of these debts, they will only need to make one single monthly payment to the lender for their debt consolidation loan.
Depending on what assets an individual has, what they owe, and what their cash flow looks like, different means of debt consolidation may be more or less viable for different people.
Should the new loan or new credit card have lower interest rates, it can become easier to pay off the debt.
Debt Consolidation Example
Let’s say an individual owes $30,000 on two different credit cards. One credit card has an APR of 27% and the other 25%, both compounded daily, and the individual owes $15,000 on each card.
To pay off their debt over a year, they’d need to pay around $2866 each month, keep track of two payments each month, and pay a total of about $4,390 in interest.
However, if they took out a loan that charged only 15% interest annually, for the amount of $30,000, they could pay off the debt in the same amount of time, paying closer to $2700 each month, only keeping track of one bill, and paying about $2492 in total interest.
This individual could theoretically consolidate credit card debt, save nearly two thousand dollars and still pay off their debt in the same amount of time.
How to Consolidate Your Debt
Understand Your Credit
First, you’ll want to get a better understanding of your credit. You can do this by requesting a credit report and finding your credit score.
This will help you understand two things better:
- where you stand regarding creditworthiness
- what you can expect from lenders or creditors based on your credit score
Understand Your Finances
Compile a master list of your finances month-to-month. This will include what you earn monthly, what bills you pay each month and everything you owe.
Determine how much interest you’re paying, your monthly payments total, and how much you’re taking home every month.
Calculate your DTI, or debt-to-income ratio, so you have a target to cut down.
Determine What’s Right For You
Now that you’ve figured out your cash flow, debts, and credit score, you can formulate an action plan.
Ask yourself if consolidating your debt is the best option for you. If so, compare various methods of consolidation. Consider your credit score, assets, and what is available.
Apply and Pay Off
Once you’ve decided what’s best for you and created a debt consolidation plan, all that’s left to do is apply for your loan or credit card and keep up with your fixed monthly payments.
Pros and Cons of Debt Consolidation
- Can simplify debt: by consolidating payments, you can make each month simple.
- Can lower total interest: new loans might have better interest rates.
- Can improve chances of paying off debts: by consolidating debt and making it more manageable, you can make it easier to pay off.
- Borrowers can inadvertently end up owing more in interest: If you’re not careful, you can end up with a new loan or credit card that’s more expensive. Simply consolidating doesn’t guarantee better interest rates.
- It can be a suboptimal move for certain situations: depending on your unique circumstances, it’s possible that filing for bankruptcy, settling loans, or making budgetary changes might be a more viable option.
- Can create additional debt: if you consolidate your debt into a loan that doesn’t have advantages, you might end up creating additional debt for yourself.
- Can lower credit score: Using debt consolidation companies or negotiating a new loan can impact your credit score.
Types Of Loans You Can Use For Debt Consolidation
A personal loan consists of an individual borrowing a set amount from a bank or other financial institution, which they must pay back by a specific time with interest. Payments are generally made monthly.
So, to consolidate debt, the individual might attempt to negotiate the best possible interest rate and repayment period directly with their creditors.
You can use this product to cover existing commercial debts and any other costs associated with running a business.
Business loans usually have more extended repayment periods than personal loans and may even have lower interest rates.
It’s important to research the options available when considering taking out a business loan to consolidate debt.
Lenders may offer different terms and conditions, so it’s best to carefully review any offers before signing up for a loan.
Debt Consolidation Loans
These products are specific to consolidate debt. In this case, the lender is the one that will pay the previous creditors, not the individual or business.
The repayment period for a debt consolidation loan can range from three to five years and is usually fixed-rate. Interest rates will depend on credit score, loan amount, and the length of the repayment period.
Individuals who can secure a credit card with lower interest payments than what they’re paying on existing debts may choose to consolidate their debt using a new credit card.
Credit cards can have highly complex interest rates. However, that might change over time or depend on what the card is being used for.
It’s important to carefully review how issuers calculate interest on any potential credit card and whether interest rates are subject to change.
Home Equity Loan
While securing an unsecured personal loan with competitive interest can be challenging, some individuals can secure better interest rates with a secured loan. One type of secured loan is a home equity loan.
In a home equity loan, the borrower’s equity in their home backs the loan. In the event of default, the lender has the borrower’s home equity to turn to, so lenders might feel more secure offering better interest rates.
Balance Transfer Credit Card
These are credit cards designed specifically to allow cardholders to pay off debts.
People can transfer balances right to the card to pay them off. Credit card companies might offer a low-interest introductory period, during which they will charge very little or even, in some cases, no interest.
Borrowers might use a balance transfer card to pay off their entire balance within the introductory period.
In any event, it’s essential to review the card’s terms and understand how long any such introductory period lasts, as well as what the interest will look like afterward and if there are fees for transferring a balance.Learn about the best loans to consolidate debts
Factors to Consider Before Taking Out a Debt Consolidation Loan
Consider The Interest Rate
In any situation, think about what your interest rate will look like after consolidation. Is it lower or higher than the interest on the previous loans?
If you’re considering using a credit card to consolidate your debt, be mindful of whether a credit card’s interest rates are subject to change. If they’re subject to change, be sure to understand in what cases they are.
If interest rates on consolidation loans available to you aren’t better than your initial interest rates, you may end up owing more money in the long run.
Think Long Term
You want to get your monthly payments lowered and simplified, but be mindful of the long-term future.
Consider how debt consolidation might affect your credit, whether you’re subject to changing interest rates over time or if any new loan you take out has a specific repayment period that you must meet.
If you’re considering a balance transfer credit card, remain mindful of transfer fees, when any introductory interest periods end, and what your backup plan is should you overextend yourself.
Most Common Debt Consolidation Loan Requirements
- Proof of income. This is especially true if you don’t have any collateral. This lets lenders know what you can afford to take on and informs how they might set things such as interest rates.
- Debt to credit ratio. If your debt is too high, it’s possible that you won’t be able to qualify for a consolidation loan.
- Creditworthiness. Lenders want to ensure you are a responsible borrower, so having a good credit score is essential in qualifying for a consolidation loan.
- Bank account information. Many lenders require you to have a bank account before they lend you money, so having one ready can be beneficial when applying for a debt consolidation loan.
- Proof of Identification. Lenders need to know to who they are lending money, so proof of identity is a standard requirement. Without the proper identification, the lender may be unable to approve you.
Debt Consolidation Alternatives
Getting out of debt doesn’t always require tricky financial maneuvers. Sometimes, the best way to pay off debts is by reexamining your spending.
Sometimes, it makes more sense to tighten a few belts and pay off original debts than to consolidate debt.
If you already have equity in a home on which you’re making mortgage payments, you can get a cash-out to refinance. This is when you refinance your mortgage to pay off a larger total sum, but you receive cash from your home’s equity now.
You can use this cash for nearly anything, including paying off other debts.
If you can refinance and pay lower interest than on other debts, a cash-out refinance may be a viable option.
With debt settlement, you’re working with the original lender or creditor to come up with a lower amount they’ll accept to settle your debt.
Lenders might work with borrowers on a debt settlement as they may see this as safer than risking default, and they can receive a lump sum of a considerable amount.
Debt settlement isn’t all good for borrowers, though. It can affect your credit score for years, making it more challenging to secure loans or lines of credit in the future.
Consolidate Your Business Debt
If you’re a business owner struggling with debt, consolidation can be the answer to helping you get back on track.
Not only does it help free up cash flow, but it also allows you to better manage your payments each month.
A business loan can help you take control of your finances.
By choosing the right option for your situation, you can help ensure that you stay on top of payments and reduce your overall liabilities. If you want to consolidate your business debt, consider applying for a loan today.
What is the difference between credit card refinancing vs. debt consolidation?
Credit card refinancing is when you take out a new loan to pay off existing credit card debt. This new loan usually has a lower interest rate, allowing you to save money on interest fees.
Debt consolidation involves taking all of your existing credit card debts and consolidating them into a single loan with one monthly payment.
The new loan also usually has a lower interest rate than the combination of your original credit card debts, which can save you money in the long run.
What is the best way to consolidate credit card debt?
A balance transfer is one of the most effective ways to consolidate credit card debt. A balance transfer is when you move existing debts onto another credit card with a lower interest rate.
This can significantly reduce overall monthly payments, freeing up more money for other expenses.
What is better, bankruptcy or debt consolidation?
There is no one-size-fits-all answer. It all depends on your financial circumstances and goals.
Bankruptcy can be a viable option for those who are unable to make any payments, while debt consolidation may be an appropriate strategy if you have some amount of disposable income to make payments.
Does a consolidation loan hurt your credit?
Yes, it can. If you increase the amount of debt you are carrying or take out a loan with an interest rate higher than what you previously had, this could negatively impact your credit score.
On the other hand, they make it easier to manage your monthly payments and reduce the number of creditors reporting delinquencies or defaults to the credit bureaus, which could improve your credit score.
What credit score do you need for a debt consolidation loan?
Credit scores play an important role in determining whether or not you will receive approval.
Generally speaking, lenders look for borrowers with good-to-excellent credit scores (670 or higher) when considering applicants for a debt consolidation loan.
Is debt consolidation a good idea?
Yes, debt consolidation is a great idea if you have multiple debts and are struggling to keep up with payments.
Is it a good idea to consolidate credit cards?
Yes, consolidating your credit cards is generally a good idea. It can help you pay off debt faster and reduce the interest you have to pay over time. Consolidating your credit cards also makes managing all your payments more manageable.
What is the best way to consolidate and pay off debt?
The best approach is to create a budget that allows you to make consistent payments toward your debt. Start by identifying which debts have the highest interest rates and focus on those first.
You can also consider transferring balances of high-interest credit cards to one with a lower rate. If your credit score allows, you can consider taking out a personal loan or using a home equity line of credit to pay off your debt.
What is a debt consolidation loan?
A debt consolidation loan is a type of loan that allows borrowers to combine multiple debts into one. This can be an effective way of managing debts, as it simplifies the repayment process and can improve overall financial health.
How to get a debt consolidation loan?
Gather all of your current bills together to accurately understand how much money you owe each month. Check availability with different lenders, prepare financial documents, and secure proper financing.
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