What Is Debt Consolidation?

Debt consolidation refers to the act of taking out a new loan to pay off other liabilities and consumer debts. Diverse debts are consolidated into a single, more substantial loan with often more favorable settlement terms—a lower interest rate, a cheaper monthly payment, or both—than a single, larger obligation. Debt consolidation can be used as a strategy to cope with student loan debt, credit card debt, and other responsibilities.

HOW DEBT CONSOLIDATION WORKS

Debt consolidation is the process of using several types of finance to pay down other debts and responsibilities. If you have a variety of debts, you can apply for a loan to combine them into a single liability and pay them all off. The additional debt is then paid on until it is completely paid off.

As a first step, most consumers apply for a debt consolidation loan through their bank, credit union, or credit card provider. It's an excellent place to start, especially if you have a solid relationship with your bank and a decent payment history. If you've been rejected down, look into private mortgage businesses or lenders for a second chance.

For a variety of reasons, creditors are willing to do so. Debt consolidation increases the likelihood of a debtor being paid. Financial organizations such as banks and credit unions typically offer these loans, however there are other specialized debt consolidation service companies that offer similar services to the general public.

DEBT CONSOLIDATION vs. DEBT SETTLEMENT

It's vital to remember that debt consolidation loans don't completely eliminate the initial debt. Instead, they simply move a consumer's loans to a different lender or type of credit. For true debt relief or for individuals who don't qualify for loans, it may be advisable to look into a debt settlement rather than, or in conjunction with, a debt consolidation loan.

Rather than reducing the number of creditors, debt settlement tries to lower a consumer's responsibilities. Debt-relief organizations and credit counseling services are available to consumers. Instead of making genuine loans, these companies strive to renegotiate the borrower's present debts with creditors.

TYPES OF DEBT CONSOLIDATION

Debt consolidation loans are divided into two categories: secured and unsecured loans. One of the borrower's assets, such as a house or a car, is used to secure a secured loan. In turn, the asset serves as the loan's collateral.

Loans that are not secured by assets, on the other hand, can be more difficult to obtain. They also have higher interest rates and fewer qualifying amounts than other types of loans. Interest rates on either sort of loan are often lower than those on credit cards. The rates are usually fixed, so they do not change throughout the course of the repayment period.

By combining your bills into a single payment, you may do a number of things. A few of the most common are listed here.

LOANS FOR DEBT CONSOLIDATION

Debt consolidation loans are offered by many lenders, including traditional banks and peer-to-peer lenders, as part of a payment plan to borrowers who are having trouble managing the amount or size of their outstanding obligations. These are intended for customers who desire to consolidate multiple high-interest debts.

CREDIT CARDS

Another option is to transfer all of your credit card payments to a new card. If this new card charges little or no interest for a certain period of time, it could be a good concept. Alternatively, you can use the balance transfer feature of an existing credit card, especially if the transaction is eligible for a special offer.

HELOCs

Debt consolidation can also be accomplished via home equity loans or home equity lines of credit (HELOCs).

PROGRAMS FOR STUDENT LOANS

For consumers with student loans, the federal government offers a variety of consolidation options, including direct consolidation loans through the Federal Direct Loan Program. The weighted average of the prior loans is used to calculate the new interest rate. However, private loans are not eligible for this program.

CONSOLIDATION LOANS: BENEFITS AND DRAWBACKS

There are benefits and drawbacks to debt consolidation loans if you're thinking about it.

ADVANTAGES

In particular, consumers who owe $10,000 or more can benefit from debt consolidation if they have many obligations with high interest rates or monthly payments. You can profit from a single monthly payment instead of many payments, as well as a lower interest rate, by negotiating one of these loans.

You can also look forward to becoming debt-free sooner if you don't take up any new loan. If the new loan is kept up to date, going through the debt consolidation process can reduce calls or letters from collection agencies.

DISADVANTAGES

Although the interest rate and monthly payment may be lower on a debt consolidation loan, it's vital to pay attention to the payment plan. Longer payment terms mean that you'll have to pay more in the long run. Contact your credit card issuer(s) to find out how long it will take to pay off debts at their existing interest rate, and compare it to the potential new loan if you're considering consolidation loans.

Special arrangements on student debt, such as interest rate discounts and other rebates, may also be lost. These provisions may be lost as a result of debt consolidation. In most cases, those who fail on consolidated student loans have their tax refunds taken, and their income may even be garnished.

CREDIT SCORES AND DEBT CONSOLIDATION

A debt consolidation loan may improve your credit score in the long run. Paying off the principal component of the loan sooner can keep interest payments low, leaving you with less money in your pocket. As a result, your credit score may improve, making you more appealing to future creditors.

At the same time, transferring old loans to a new one may have a negative impact on your credit score at first. Because credit scores prefer debtors with a longer, more consistent payment history, this is the case.

Close out existing credit accounts and open a single new one, for example, may reduce the overall amount of credit accessible, resulting in an increase in your credit use ratio.

DEBT CONSOLIDATION REQUIREMENTS

Borrowers must have the requisite income and creditworthiness to qualify, especially if they are dealing with a new lender. A letter of employment, two months' worth of statements for each credit card or loan you want to pay off, and letters from creditors or repayment agencies are the most frequent pieces of evidence you'll need, though the type of documents you'll need will vary depending on your credit history.

After you've established your debt consolidation strategy, you should think about who you'll pay off first. In many circumstances, your lender, who may pick the order in which creditors are repaid, will decide. As a last resort, pay off your highest-interest debt. It's possible that you'll want to start with a lower-interest debt if it's giving you more emotional and mental stress than the higher-interest ones (such as a personal loan that has damaged family relations).

DEBT CONSOLIDATION EXAMPLES

Consider the following scenario: you have three credit cards and owe a total of $20,000 at a compounded monthly rate of 22.99 percent. To reduce the sums down to zero, you'd have to pay $1,047.37 per month for 24 months. Over time, this works up to $5,136.88 paid in interest alone.

To bring the total to zero, you'd have to pay $932.16 each month for 24 months if you consolidated the credit cards into a lower-interest loan with an 11 percent annual rate compounded monthly. This equates to a $2,371.84 interest payment. Over the life of the loan, the savings would be $2,765.04 with a monthly savings of $115.21.

Even if your monthly payment remains the same, simplifying your loans can help you save money. Let's say you have three credit cards with an annual percentage rate of 28 percent (APR). Your credit cards are each maxed up at $5,000, and you're paying the minimum payment on each card for $250 every month. If you paid off each credit card separately, you'd have to spend $750 every month for 28 months to pay a total of $5,441.73 in interest.

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