Debt consolidation, in simplest terms, means using one new form of financing to pay off other previous debts. (multiple liabilities and consumer debts).
In other words, Combine multiple old debts into a new single one, making payments more manageable or the payoff period shorter.
There are several ways to achieve this. One method is to combine all previous credit card payments into a new credit card so that it reflects the current situation as a whole.
This works especially if the new credit card charges little or close to no interest for a specific period.
Home equity loans are another way of debt consolidation, which may help some people getting back on their feet.
Usually, the interest for this type of loan is tax-deductible, which is beneficial in the long run.
Other approaches include balance transfer cards and personal loans with more manageable repayment measures. (lower interest rates, lower monthly payments, etc.)
There are specific tools that can be used called “debt consolidation loans” offered by creditors as part of a payment plan to consumers who have difficulty in managing the number /size of their outstanding debts.
Most often, they are willing to do this for several reasons.
One is that it maximizes the likelihood of collecting from a debtor.
These loans usually are offered by financial institutions, but there are also specialized debt-consolidation service companies such as Lightstream, prosper, upstart, etc.
What types of loans are there?
There are two types of loans that are offered by creditors:
Secured loans are backed by an asset of the borrower’s (a house/ a car) that is collateral for the duration while unsecured loans such as debt consolidation loans are not and can be more challenging to obtain.
With either case, the interest rates usually are lower than the rates on most credit cards, and most rates are fixed, and that can be quite a relief.
It is essential to remember that these loans don’t get rid of the original debt.
They transfer all your existing loans to a different lender/type of loan.
If you need actual debt relief or don’t qualify for loans, the best choice would be to look into a “debt settlement.”
Debt settlement aims to reduce your commitments rather than just reducing the number of creditors.
You usually work with a debt-relief company or credit-counseling services who then try to renegotiate the borrower’s current debts with creditors.
Of course, borrowers must have the income and good credit necessary to qualify with a new lender, who can offer them a lower rate.
The most commonly required information includes a letter of employment, two months’ worth of bank statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.
Once your debt-consolidation is in place, your lender may choose the order in which creditors are repaid.
If not, you should start by paying off your highest-interest debt first.
This will also stop collection agencies from calling and bothering you about the outstanding debt, which causes a lot of stress and headaches.
Debt consolidation loan interest payments are also often tax-deductible when home equity is involved.
All that being said, some pitfalls consumers could face when consolidating debt are, extending the loan term, hurting their credit score, jeopardizing their assets, missing out on special terms/benefits as well as paying much money to a debt consolidation service.
Consolidating debt alone does not get you out of debt; improving saving habits does.
If you do combine your debts, resist the temptation to use your credit cards again, or one may be faced with the almost impossible task of paying for both at the same time.
Success with a consolidation strategy requires the following criteria:
- The total debt excluding mortgage doesn’t exceed 40% of your gross income,
- The credit score is good enough to qualify for a 0% credit card or low-interest debt consolidation loan,
- Current cash flow consistently covers payments toward your debt and having a plan to prevent debt from racking up again.
Hypothetically, if one has four credit cards with interest rates ranging from 18% to 25%, they might qualify for an unsecured debt consolidation loan at 7% where there is a clear and remarkable difference in interest fees.
Typically this is given on the premise that payments are made on time, so your credit score remains good.
Debt consolidation works if it includes a plan to prevent racking up debt again.
Read our post about how to stay out of debt
If your debt load is small and you can pay it off at the current pace, then consolidating will prove to be not that effective.
Similarly, if the total of your debts is more than half your income, debt consolidation is not the answer.
Here, a couple of DIY debt payoff methods can be incorporated instead, namely “debt snowball” and “debt avalanche.”
The debt snowball is where you focus on paying off your smallest debt first, roll the amount you had been paying on it into payments on the next most considerable debt recorded on your file.
The debt avalanche is when someone begins to pay off their debt with the highest interest rate first, then the next highest rate, and so on. It may save time and money in the duration of your debt payoff.
In conclusion, replacing several various loans with one fixed-rate monthly payment can simplify life. Don’t consolidate just for convenience, however.
Unless you’re overwhelmed by multiple payment dates, the ease of a single monthly payment alone is not a sufficient reason to consolidate debt, as explained in the pitfalls mentioned above.