Juggling several loans can be as challenging as it can be stressful. Many have found themselves scrambling to remember a due date or wincing at the sight of high interest rates on multiple credit cards. If you’re wondering what debt consolidation is and how it can help, it’s a possible lifeline for those drowning in scattered monthly payments.
Debt consolidation allows you to combine multiple debts into a single payment, usually at a lower interest rate. According to a Forbes Advisor survey of borrowers who took out personal loans to consolidate debt, 59% managed to consolidate all their existing debts into one loan. And you could do it too.
This blog examines debt consolidation and whether it’s a good option for you. Read on to learn more!
Key Takeaways
- Debt consolidation simplifies your finances by rolling multiple debts into one loan, potentially at a lower interest rate.
- Secured and unsecured consolidation loans involve different risks, so be clear about what you’re willing to take on.
- Carefully compare interest rates and fees of different debt consolidation types to ensure this strategy saves you money.
- If consolidation doesn’t suit your situation, alternative strategies, such as debt management plans or balance transfers, may be more suitable.
- Regardless of the debt relief method you choose, you must address the root cause of your debt to achieve lasting financial health.
What Is Debt Consolidation?
If you have been wondering about debt consolidation, it refers to bundling multiple debts, such as credit cards, personal loans, or medical bills, into one manageable loan, usually at a lower interest rate. The idea is to simplify your finances and reduce your total debt amount.
Combining various debts into a single payment means you no longer have to juggle multiple due dates or statements, which can alleviate much financial stress. Furthermore, debt consolidation can shorten your repayment timeline, helping you become debt-free sooner.
Types of Debt Consolidation
In general, debt consolidation loans can be of two types: secured and unsecured. Secured loans require collateral, such as a valuable asset such as your home, which can be confiscated if you fail to repay the loan. These are easier to qualify for and have lower interest rates, but they involve the risk of losing your assets.
On the other hand, unsecured loans aren’t backed by anything. However, they are usually more challenging to qualify for and have higher interest rates than secured loans.
Whether the loan is secured or unsecured, you can consolidate your debts using common loan types or credit cards.
- Personal loans are unsecured loans from a bank or credit union that provide a lump sum payment and require monthly repayments. Terms and rates are generally more favorable than for credit cards but vary based on your credit score, income, and lender policies. The average interest rate is about 12.5%.
- Credit cards can help you lift the burden of your current debts if they offer lower interest rates. The average credit card interest rate is 20%. Some credit cards offer promotional 0% introductory APR that you can take advantage of to lower the total costs.
- Home equity loans or home equity lines of credit (HELOC) allow you to borrow against the equity in your home, often at lower interest rates than unsecured loans. The average interest rate currently is 8.3%. The risk is that your home serves as collateral, so missing payments can lead to foreclosure.
- Federal Direct Loan Program offers debt consolidation options for those with student loans. This program, backed by the federal government, gives an interest rate that is the weighted average of your existing debts. This won’t necessarily lower your total interest costs, but it can simplify repayment by consolidating all your debts into one monthly bill.
Please note that the interest rates listed above are for illustrative purposes only. Rates vary by lender and credit profile.
How Does Debt Consolidation Work?
Instead of managing several monthly bills, debt consolidation rolls all your debts into one payment. If done correctly, this simplifies your budgeting and reduces stress.
Here’s how it works. To apply for a debt consolidation loan, you start by gathering all the necessary documents about your current debts, including account balances, interest rates, and monthly payments. Next, you identify which consolidation method works best for you, whether a personal loan or federal loan consolidation.
If approved, you can start using the funds from the new loan to pay off your credit card debt. From there, you will focus on paying back the single new loan or credit line, ideally at a more favorable interest rate.
You owe $12,000 across three credit cards at an average APR of 18%. If you decide to pay that off over two years, you might pay around $600 monthly, with about $2,300 going toward interest. Suppose you consolidate those balances into a personal loan at 10% APR over the same period. Your monthly payment could drop to about $554, and you’ll pay closer to $1,300 in interest.
Pros and Cons of Debt Consolidation
Before deciding if this loan product is right for you, it can help to clarify what debt consolidation is in practical terms and whether it aligns with your financial goals. Here are the main pros:
- You roll all your debts into a single loan or line of credit, leaving you with just one due date for all your payments.
- You could get a lower interest rate and save money over time.
- Managing finances can be more manageable with a single statement and single lender.
- A fixed term and interest rate make your monthly expenses more predictable.
- Consolidation also brings peace of mind by streamlining your debts into one manageable plan.
- Lower monthly payments can free up space in your wallet, letting you save more.
- If you make consistent and timely payments, your credit score may improve.
- Watching that single balance decrease each month can motivate and encourage healthier financial habits.
On the other hand, these are the possible drawbacks of debt consolidation:
- Lower interest rates aren’t guaranteed.
- Some consolidation loans may incur additional fees, including balance transfer, origination, and closing costs. These can significantly offset the potential savings from consolidation.
- Your credit score may initially dip due to a hard inquiry.
- It doesn’t fix the underlying issue of debt.
- If you miss payments, the consequences can be even worse than before.
Alternatives to a Debt Consolidation
Sometimes, the answer to “Should I consolidate my” isn’t a straightforward yes. First, lower interest rates may not always be available, so it wouldn’t make sense to go for it. Next, your debt load may be too high to make consolidation cost-effective. In these cases, you might look at other alternatives.
Below are some common avenues you could pursue to get out of debt.
Debt Management Plan
A debt management plan (DMP) is a formal agreement between you and the lenders to pay off your unsecured debts at a reduced interest rate. A DMP typically involves working with a credit counseling agency, which can negotiate with your creditors. Like consolidation, instead of paying multiple bills, you make one monthly payment to the agency, which distributes the funds to your creditors.
The chances of getting a debt management plan vary from lender to lender. However, a lender may generally be more willing to accept the deal, as they usually seek ways to retrieve their funds as soon as possible. However, the downside of a DMP is that it can negatively impact your credit score and require you to close or freeze your credit card accounts.
Debt Settlement Program
In a debt settlement program, you or a settlement company negotiates with creditors to pay a lump-sum amount that’s less than your total outstanding debt. The rationale is that creditors prefer receiving even a part of the debt rather than risking total default.
You can negotiate a debt settlement program yourself or with the help of a debt settlement company. If successful, this option can significantly reduce the total amount you owe and provide faster relief if you’re already behind on payments. However, it can dramatically impair your credit score, and forgiven debt may be taxed as income.
Balance Transfer Credit Card
If your credit is excellent, a balance transfer credit card could be an option. These cards can help you move high-interest debt to a new one with a 0% introductory interest rate, often lasting 6 to 18 months.
A balance transfer credit card can temporarily save you a lot of money in interest. It consolidates your debts into one card. However, these cards usually charge a transfer fee of 3% to 5% and come with high interest rates after the promotional period.
Cash-Out Refinance
Homeowners with sufficient equity and excellent credit may consider a cash-out refinance. This method involves taking out a new mortgage than you currently owe and using the extra funds to cover high-interest debts. It effectively rolls your debt into your mortgage.
Cash-out refinances offer lower interest rates than credit cards or personal loans and combine multiple debts into a single mortgage payment. However, closing costs can be high, and since it converts unsecured debt into secured debt, foreclosure of your property is a risk if you default. Additionally, it extends the total term you’ll be paying off your home.
Bankruptcy
In the worst-case scenario, filing for bankruptcy may be the last resort option. Bankruptcy is a legal process that can either eliminate (Chapter 7) or restructure (Chapter 13) many types of debt under court protection. It can provide relief if you’re facing insurmountable debt, but it does damage your credit score severely and stays on your report for 10 years. Moreover, court and attorney fees can be high, and some debts like student loans or tax liens aren’t typically discharged.
FAQ
Does Debt Consolidation Hurt My Credit?
Your credit score may initially decline, as a new loan can trigger a hard inquiry. However, if you make payments on time, your credit score will improve in the long run, as your payment history is one of the most significant factors in determining your credit score.
Is Consolidating Debt a Good Idea?
Debt consolidation is a good idea when the new interest rate is lower than you currently pay. You should also ensure the new monthly payment plan is manageable within your budget. On the other hand, consolidation may not be the best solution if the latest interest rate and debt management plan are not substantially better, and if you’re likely to accumulate more debt.
What Qualifies You for Debt Consolidation?
You need an excellent credit score of 690 or higher to qualify. However, some lenders may look at other factors, including your employment and current income streams, to determine your creditworthiness. A good debt-to-income ratio can also improve your chances of qualifying for debt consolidation.