You want to pay off debt but don’t quite know where to start. Debt consolidation is an option that can be effective if appropriately leveraged. Here’s how it works, along with a breakdown of the benefits, drawbacks and how to decide if it’s ideal for you.
How Does Debt Consolidation Work?
Debt consolidation is a strategy individuals use to streamline the debt repayment process, save on interest and possibly get out of debt faster. It merges multiple debts into a single loan product, so you’ll make a single payment instead of several each month.
Debt Consolidation Pros and Cons
Before you consolidate your debt, consider the benefits and drawbacks.
Benefits of Debt Consolidation
- You could get a lower interest rate.
- You could get a lower monthly payment.
- You could pay off your debt faster.
- Your credit score could improve.
Drawbacks of Debt Consolidation
- You could be assessed balance transfer or loan origination fees.
- You could get an extended repayment period and pay more in interest over the loan term.
- You could rack up more debt if you’re not disciplined with your spending.
- You could mask the source of deeply-rooted financial problems.
When Should You Consolidate Your Debt?
Debt consolidation could be a smart money move if you have a steady source of income and good or excellent credit. You’ll likely qualify for credit cards or loans with lower interest rates than you currently have.
It’s also essential to have a solid spending plan and enough income to make timely payments on your debts. Otherwise, you could struggle to keep the debt consolidation loan or credit card in good standing and could damage your credit rating.
But suppose you owe small balances that can be paid off within six months to a year. In that case, it may be more sensible to pay more than the minimum each month to get out of debt without consolidating. You won’t have to pay balance transfer or loan origination fees and could still meet your goal in a reasonable amount of time.
What Are the Risks of Debt Consolidation?
Debt consolidation could be risky if you have trouble keeping your spending under control. When you consolidate your credit cards, you wipe out the balances and give yourself a clean slate. But if you resort right back to the plastic to make purchases without paying the balances in full in each, your plan to get out of debt will backfire. Even worse, you’ll end up with far more debt than you started with.
If you are experiencing financial difficulties and can’t afford monthly payments, steer clear of debt consolidation. The same rule applies to excessive debt balances. If you owe more than 50 percent of your income, debt consolidation may not be the most ideal option. It could be more sensible to work with a debt relief company to possibly settle your outstanding balances for less than you owe or risk doing more damage to your credit health.
Ways to Consolidate Debt
Ultimately, consolidating your debt means you could be out of the hole sooner than later. So, you want to choose a loan or credit card product wisely. These options are worth considering:
Debt Consolidation Loan
Traditional banks, online banks, credit unions and online lenders offer personal loans disguised as debt consolidation loans. The interest is fixed, which means you’ll make equal monthly payments until the balance is paid off.
For debt consolidation loans to be effective, the interest rate should be lower than what you’re currently paying on your existing debts. Furthermore, you want to use the loan proceeds to pay off debt and not fund other big-ticket purchases (as there are no restrictions on how the funds can be used).
Credit Card Balance Transfer
Balance transfer credit cards offer a 0 percent promotional interest rate for a set period. You’ll need good to excellent credit to qualify. If approved, you can roll high-interest debts over to the new card to save a bundle in interest. That’s assuming you repay the total outstanding balance before the zero-interest window ends.
This strategy can be effective if you refrain from using the paid-off cards – if not, it’ll backfire and cause you a fortune in interest. You also want to be mindful of the fees as some balance transfer credit cards charge 3 percent of the total amount transferred over.
Student Loan Consolidation
You can consolidate multiple federal student loan balances into a Direct Consolidation Loan. It’s a relatively simple process that can be completed online. Your loans will be combined into a new loan product with one monthly payment. Even better, you will still have access to federal loan protections, forgiveness programs and repayment options.
However, private student loans aren’t eligible for consolidation through a Direct Consolidation Loan. However, some private lenders could be willing to consolidate your loan balances. Or you can refinance the balances to get a lower interest rate. Inquire with your loan servicer to learn more.
Home Equity Loan
Do you have a sizable amount of equity in your home? If so, you could qualify for a home equity loan to consolidate your debts. Most lenders allow homeowners to borrow between 80 to 90 percent of the property value minus the outstanding mortgage balance. To illustrate, assume your home is worth $375,000 and you owe $295,000 on the mortgage. You could qualify for between $5,000 ($375,000 * .80 – $295,000) and $42,500 ($375,000 * .90 – $295,000) in funding.
Loan proceeds are dispersed in a lump sum payment, and you can use them however you see fit. Expect a fixed interest rate and a repayment term of up to 20 years.
Home equity loans should only be used as a last resort. They act as a second mortgage and use your property as collateral. Consequently, you could lose your home if you fall behind on loan payments.
Work with Debt Experts to Find the Fastest Way to Get Out of Debt
As mentioned earlier, overwhelming debt typically isn’t resolved by consolidating, especially if you can’t afford the minimum monthly payments. Fortunately, it’s still possible to find relief so you can get back on track financially.
Debt settlement could be an option worth considering. You can reach out to creditors on your own or let the professionals do the work for you.
