Are you tired of paying creditors each month? You may have considered debt consolidation to pay off your debt faster but aren’t sure what options are available. Or maybe you worry about the impact it’ll have on your credit score.
Debt consolidation could work for your financial situation, but you should consider the benefits and drawbacks before deciding. It’s equally important to understand that better options may be available if you struggle to stay afloat financially.
What Is Debt Consolidation?
Debt consolidation involves combining several debts into a new credit product. The idea is to streamline the repayment process as you’ll only pay a single creditor each month. You could also save a bundle if the interest rate on the new loan is lower than what you’re currently paying on your outstanding debt obligations.
Does Debt Consolidation Hurt Your Credit History?
When applying for a debt consolidation loan, your credit score could temporarily drop a few points from the hard inquiry. Plus, your average age of accounts will be slightly lower, which could ding your credit score.
However, you’ll typically see an increase if you use the loan proceeds to pay off credit card balances, as it lowers your credit utilization ratio. But, you’ll have to wait for the creditors to report updated balances to the credit bureaus.
A debt consolidation loan can help your credit mix, which accounts for 10 percent of your credit score. In addition, your payment history, the most significant component of your credit score, will also improve as you make timely payments over the loan term.
Debt Consolidation vs. Debt Settlement
Some individuals confuse debt consolidation with debt settlement, but they aren’t quite the same. Debt consolidation aims to get you out of debt faster by merging multiple debts into one product with a lower interest rate. To qualify for a loan with competitive terms, you’ll need good or excellent credit.
Debt settlement is also a strategy commonly used to eliminate pesky debt balances faster. However, it involves negotiating settlement offers for a fraction of what’s owed and could have severe consequences for your credit health. There are no credit score requirements, and only unsecured debts are eligible for inclusion in a debt settlement program. Plus, you won’t pay interest to the debt settlement company since you’re not taking out a loan, but fees apply each time a debt is settled.
Debt Consolidation Options
You can use a debt consolidation loan, balance transfer credit card or home equity line of credit (HELOC) to consolidate your debt.
Debt Consolidation Loans
Debt consolidation loans are a type of personal loan offered by traditional banks, credit unions and online lenders. They’re unsecured with a fixed interest rate, so you don’t need collateral to qualify. And the monthly payment will be the same over the life of the loan. Ideally, you want to have good or excellent credit to qualify for a low-interest rate.
If your loan application is approved, you’ll get the funds in a lump sum. Most lenders don’t have restrictions on how the loan proceeds can be used. However, you should pay off debt balances promptly and refrain from using your credit cards or applying for more credit for your strategy to work.
Credit Card Balance Transfer
Balance transfer credit cards offer zero-interest promotional periods of up to 18 months. You can move the balances from your high-interest credit cards to the new card and save several hundred or thousands of dollars in interest if you pay it off before the interest-free period ends. However, a balance transfer fee between three and five percent of the balance transferred applies.
Like debt consolidation loans, balance transfer credit cards are generally reserved for good or excellent credit consumers. Also, you want to stow the cards away once you’ve transferred the balance to avoid racking up even more debt than you started with.
Home Equity Line Of Credit
If you’ve built up a nice amount of equity in your home, you could qualify for a Home Equity Line of Credit (HELOC). Most lenders offer up to 80 percent of your equity. So, if your home is worth $425,000 and you owe $295,000 on the mortgage, you could be qualified for a HELOC of up to $45,000 ($425,000 * .80 – $295,000).
You’ll get access to a revolving line of credit that works like a credit card – you can spend up to the limit, make payments and use the same funds again.
Withdrawals are only permitted during the draw period, usually up to 10 years. You’ll also make interest-only payments on the amount you borrow during the draw period. But when it ends, the outstanding amount will be payable in monthly installments over 20 years in most instances. The interest rate on HELOCs is variable, so your loan payment may fluctuate.
Advantages Of Debt Consolidation
- You could lower your monthly debt payments.
- You could get out of debt sooner.
- You could save a fortune in interest.
- You’ll simplify the repayment process by paying a single creditor each month.
- Your credit score could improve as your credit utilization decreases.
- You’ll build positive payment history with a new loan or credit card.
Disadvantages Of Debt Consolidation
- You may not qualify for a debt consolidation loan, balance transfer credit card or HELOC with a low credit score.
- Your monthly payments could be unaffordable on a debt consolidation loan since the loan term is typically three to five years.
- If you’re not disciplined enough to stop using your credit cards, you could accumulate more debt.
- Your home could be at risk of foreclosure if you default on HELOC payments.
- If you have less than perfect credit and don’t qualify for a lower interest rate, you could spend more on interest.
Get Professional Credit Counseling
Debt consolidation can give you the much-needed relief you need, but it may not be the most ideal option if you have less than perfect credit. Furthermore, you could struggle to keep up with your monthly payments if money’s tight and you’re already living paycheck-to-paycheck.
Before you consolidate your debt, speak with a credit counselor to determine if it makes sense for your finances. It’s free through reputable agencies and only takes 30 minutes to an hour of your time.
During the session, a certified credit counselor will review your finances and help you develop a realistic budget. They will also review your debt load and suggest debt relief options that could be most effective for your financial situation and prevent you from filing bankruptcy.
