What you need to know about debt consolidation and is it the best option for you?

Different loan types with varied interest rates and due dates – these are some of the things that make you feel like there ought to be a manual for your debts. With too much confusion that comes with taking out several loans, you may be risking high interest charges and late fees. This is the best time for you to have your debts consolidated.

Debt consolidation occurs when you take out a new loan to pay off all your debts, usually unsecured ones. It involves the combination of multiple debts into one large piece of debt with favorable terms of pay-off, which includes lower monthly payments, reduced interest rates, or even both. Consumers mostly use consolidated debts to pay off their credit card debts, student loan debt, medical bills and other debt types. Thanks to consolidated debts, you can now save money by avoiding high interest rates, reduce your payment period and simplify your payments.

There are different ways consumers can use to combine their debts into one single payment. This includes combining their credit card payments into a new card. This can especially come in handy when the new card charges lower interest rates. Another method of debt consolidation is use of home equity loans. There are also debt repayment programs designed to get consumers out of debt.

debt consolidation

Breaking down ‘debt consolidation’

Generally, debt consolidation is the use of one financing method to pay off your liabilities. However, specific financial instruments, referred to as debt consolidation loans, are also issued by creditors to borrowers who have difficulties managing their debts. There are a number of reasons as to why creditors use this financing tool. The main reason is that it maximizes the chances of their debts being paid. These loans are mostly offered by credit unions, banks and other financial institution. Debt consolidation loans are available in two broad categories, secured and unsecured loans.

Secured loans use the borrower’s asset such as a car, house or rented property as collateral. Agreeing to the loan means that the lender will possess the asset if you fail to repay the loan. As much as lenders will repossess the assets if you default, you can still find yourself in debt. This is because lenders will sell the property and use the money to pay off your debt. If the proceedings are not enough to clear the debt, you will be liable to pay the difference.

Unsecured loans, on the other hand, are not tied to any of the borrower’s assets. However, these loans have a comparatively higher interest rate and you can end up qualifying for a relatively lower amount. The loan has a three to five years pay-off period.

As much as consolidated debt loans can be helpful, they are not meant to erase the debt. They only help transfer your debts to another lender. In case you need relief for your debts but do not qualify for any loan type, debt settlement can be the best option. Rather than dropping the number of creditors, debt settlement helps to reduce your financial obligation.

debt consolidation

Advantages of debt consolidation loans

Debt consolidation process involves taking a single loan to pay off all your debts. By taking out a debt consolidation loan, you will be able to consolidate all your loans into a single account. This reduces the hassle that comes with multiple payments and deadlines. Consolidating your debts will also help reduce your stress level. This is because it will help you focus on more important things rather than worrying too much about your debts. Too many debtors also come with a number of collection calls. Getting a debt consolidation loan means that you will worry less about collection calls. Another benefit of getting a debt consolidation loan is that your interest rate will reduce. This will help save a substantial amount of money. Besides, your credit score will also improve.

How does debt consolidation work?

If your debt consolidation loan is approved, the lender will pay off all your outstanding debts and convert them into one single loan. This will not only make the repayment process easier, it also saves on admin fees costs. With consolidated debt loans, the loan term will be longer than what was in your initial credit accounts, making the loan more affordable by lowering your monthly installments. But in the long run, your debt will be more costly since the amount you pay on interest will increase. For this reason, it is important that you pay your debts as soon as possible even if you used a debt consolidation loan for your monthly payments to be more affordable. After you settle all your outstanding debts, the loan account will be closed. But your credit cards will remain open. If you have challenges managing your debts in the past, it will be prudent to close them.

debt consolidation

Finding a debt consolidation loan

If you have recorded a good credit history with your financial institution, the first step will be to approach the institution for the loan. Having your bank approve the loan can be the best option. If the financial institution turns you down, you can consider approaching private lenders or mortgage companies.

How to consolidate debts

After your debt consolidation is in place, how do you decide which bill to clear first?
This will actually be decided by your consolidated debt loan lender. They are the ones who decide how your creditors will be paid. If not, you should start by paying off the debt with highest interest rate. But if you have a lower interest rate loan that is costing you sleepless nights, you can start with that loan. After payment of one debt, move to the next set of payment until you ensure that all your debts are cleared.

Potential pitfalls

When consolidating debts, there are potential pitfalls that consumers should avoid:

Extending loan term

debt consolidation With the new loan, your interest rate and monthly payments will be reduced. However, you need to pay keen attention to your payment schedule. If the payment period is significantly longer than your initial debts, you may end up paying huge amount in the long run. Lenders who offer debt consolidation loans make money by extending the payment duration. This makes them get more profits, even if they were charging a lower interest rate.

Let’s take an example, Edward has a $19,000 debt on credit card bills, a car loan debt of $12,000 and $5,500 on student loan. His total monthly payments are $1,100. He approaches a financial institution that offers debt consolidation loans which will reduce his interest rates and monthly payments to $850. Edwards gladly accepts the offer, which helps him save $325 every month. However, the longest term Edward would have spent on paying the initial debts would be five years, but the new lender wants the loan to be paid in 90 months. This means that Edward will, in the long run, pay $6,375 on interest, whereas he would have incurred a total amount of $5,875 on the initial debt.

Hurting the credit score

By converting your existing liabilities into a new loan, you will first experience a negative impact on your credit score. This is because credit scores normally favor longer debts with long, consistent payment history. If you replace the existing loan before payments are over, it is viewed negatively. You will also risk being listed as having a new, larger debt which intern will increase your risk factor. And just like any other loans, missing a debt consolidation loan payment will ultimately affect your credit report.

 

Additionally, closing your credit accounts after your debts have been settled and opening a brand new account may end up reducing the credit amount available to you, which in turn, will increase your debt-to-credit-utilization ratio. This can also have a negative impact on your credit score since most lenders regard increased ratios as less financially stable. However, if you consolidate the debts on your credit cards and improve your credit utilization ratio, your score will eventually rise.

Jeopardizing assets

In most cases, it is easier for borrowers to obtain secured loans compared to the unsecured ones. This means that you can find yourself consolidating a number of unsecured debts into one large secured debt. You may end up pledging your assets to act as collateral against this large amount than you previously had. For instance, using a line of credit or home equity loan will put your property at risk if you default payments.

Losing special terms or benefits

Students loan for instance, come with special provisions. These include rebates or discounts on interest rates that will appear when the loan is consolidated with other debts. If you do not pay your consolidated school loans, you may have your tax refunds garnished.

 

debt consolidation

Paying too much money on debt consolidated services

Such services tend to charge too much on initials and fees incurred monthly, which you may not need. You can easily consolidate the debts on your own by having a new personal loan from financial institutions or credit cards with low interest rates.

Not researching your options

When looking for a debt consolidation loan, it is important that you exhaust all the available options. Otherwise, you may not find the best solution. To qualify for an unsecured debt consolidation loan, your credit history is what determines whether the loan will be issued or not. If you have equity in a property, good credit is equally required for cash-out refinancing. If you do not qualify for a debt consolidated loan, debt settlement or seeking the services of credit counselling companies may be the best alternative for you. There are also pros and cons for both of them so it is equally important that you weigh your options.

Bottom line

Replacing a series of loans that have different interest rates into a single fixed loan with single monthly payments can make your life much easier and stress-free. However, do not only consolidate our loans for convenience purposes, unless the different payments dates are extremely overwhelming. The ease that comes with single monthly payments is not reason enough to consolidate your debts considering that there are also pitfalls to think through.

 

It is also important to remember that applying for a consolidated loan alone will not get you out of debt. You similarly need to improve your saving and spending habits. After your debts have been consolidated, try as much to avoid having credit card balances again. Otherwise, you will find yourself repaying both your consolidated loans and the debts altogether. Debt consolidation is just a tool designed to help consumers get out of debt, and not get into more costly debts.

debt consolidation