What Is Debt Consolidation? When Is It A Good Idea?

Debt consolidation is an option for those who have multiple debts. People might consolidate their debt for several reasons. These might include simplifying their finances, securing better interest rates, or decreasing their time to pay off debts. We'll explore what it is, how people consolidate their debt, and the potential benefits and drawbacks.

What Is Debt Consolidation?

Debt consolidation is the process of taking multiple debts and paying them off with another financial product, so you only have a single debt. The Consumer Finance Protection Bureau describes debt consolidation as when:

"various debts–whether credit card bills or other loan payments–are rolled into one loan or monthly payment."

Consolidating debts can help borrowers simplify their finances and get out of debt sooner in certain situations. These debts might be personal loans, credit cards, student loans, or others.

How Does Debt Consolidation Work?

Once the person in question has applied for and received a debt consolidation product, they can begin making payments to pay off the balances on their existing loans. After the borrower pays in full all of these debts, they will only need to make one single monthly payment to the lender for their debt consolidation loan. Depending on what assets an individual has, what they owe, and what their cash flow looks like, different means of debt consolidation may be more or less viable for different people. Should the new loan or new credit card have lower interest rates, it can become easier to pay off the debt.

Debt Consolidation Example

Let's say an individual owes $30,000 on two different credit cards. One credit card has an APR of 27% and the other 25%, both compounded daily, and the individual owes $15,000 on each card. To pay off their debt over a year, they'd need to pay around $2866 each month, keep track of two payments each month, and pay a total of about $4,390 in interest. However, if they took out a loan that charged only 15% interest annually, for the amount of $30,000, they could pay off the debt in the same amount of time, paying closer to $2700 each month, only keeping track of one bill, and paying about $2492 in total interest. This individual could theoretically consolidate credit card debt, save nearly two thousand dollars and still pay off their debt in the same amount of time.

How to Consolidate Your Debt

Understand Your Credit

First, you'll want to get a better understanding of your credit. You can do this by requesting a credit report and finding your credit score. This will help you understand two things better:

• where you stand regarding creditworthiness
• what you can expect from lenders or creditors based on your credit score

Understand Your Finances

Compile a master list of your finances month-to-month. This will include what you earn monthly, what bills you pay each month and everything you owe. Determine how much interest you're paying, your monthly payments total, and how much you're taking home every month. Calculate your DTI, or debt-to-income ratio, so you have a target to cut down.

Determine What's Right For You

Now that you've figured out your cash flow, debts, and credit score, you can formulate an action plan. Ask yourself if consolidating your debt is the best option for you. If so, compare various methods of consolidation. Consider your credit score, assets, and what is available.

Apply and Pay Off

Once you've decided what's best for you and created a debt consolidation plan, all that's left to do is apply for your loan or credit card and keep up with your fixed monthly payments.

Pros and Cons of Debt Consolidation

Pros

• Can simplify debt: by consolidating payments, you can make each month simple.
• Can lower total interest: new loans might have better interest rates.
• Can improve chances of paying off debts: by consolidating debt and making it more manageable, you can make it easier to pay off.

Cons

• Borrowers can inadvertently end up owing more in interest: If you're not careful, you can end up with a new loan or credit card that's more expensive. Simply consolidating doesn't guarantee better interest rates.
• It can be a suboptimal move for certain situations: depending on your unique circumstances, it's possible that filing for bankruptcy, settling loans, or making budgetary changes might be a more viable option.
• Can create additional debt: if you consolidate your debt into a loan that doesn't have advantages, you might end up creating additional debt for yourself.
• Can lower credit score: Using debt consolidation companies or negotiating a new loan can impact your credit score.

Types Of Loans You Can Use For Debt Consolidation

Personal Loan

A personal loan consists of an individual borrowing a set amount from a bank or other financial institution, which they must pay back by a specific time with interest. Payments are generally made monthly. So, to consolidate debt, the individual might attempt to negotiate the best possible interest rate and repayment period directly with their creditors.

Business Loan

You can use this product to cover existing commercial debts and any other costs associated with running a business. Business loans usually have more extended repayment periods than personal loans and may even have lower interest rates. It's important to research the options available when considering taking out a business loan to consolidate debt. Lenders may offer different terms and conditions, so it's best to carefully review any offers before signing up for a loan.

Debt Consolidation Loans

These products are specific to consolidate debt. In this case, the lender is the one that will pay the previous creditors, not the individual or business. The repayment period for a debt consolidation loan can range from three to five years and is usually fixed-rate. Interest rates will depend on credit score, loan amount, and the length of the repayment period.

Credit Card

Individuals who can secure a credit card with lower interest payments than what they're paying on existing debts may choose to consolidate their debt using a new credit card. Credit cards can have highly complex interest rates. However, that might change over time or depend on what the card is being used for. It's important to carefully review how issuers calculate interest on any potential credit card and whether interest rates are subject to change.

Home Equity Loan

While securing an unsecured personal loan with competitive interest can be challenging, some individuals can secure better interest rates with a secured loan. One type of secured loan is a home equity loan. In a home equity loan, the borrower's equity in their home backs the loan. In the event of default, the lender has the borrower's home equity to turn to, so lenders might feel more secure offering better interest rates.

Balance Transfer Credit Card

These are credit cards designed specifically to allow cardholders to pay off debts. People can transfer balances right to the card to pay them off. Credit card companies might offer a low-interest introductory period, during which they will charge very little or even, in some cases, no interest. Borrowers might use a balance transfer card to pay off their entire balance within the introductory period. In any event, it's essential to review the card's terms and understand how long any such introductory period lasts, as well as what the interest will look like afterward and if there are fees for transferring a balance. Learn about the best loans to consolidate debts

Factors to Consider Before Taking Out a Debt Consolidation Loan

Consider The Interest Rate

In any situation, think about what your interest rate will look like after consolidation. Is it lower or higher than the interest on the previous loans? If you're considering using a credit card to consolidate your debt, be mindful of whether a credit card's interest rates are subject to change. If they're subject to change, be sure to understand in what cases they are. If interest rates on consolidation loans available to you aren't better than your initial interest rates, you may end up owing more money in the long run.

Think Long Term

You want to get your monthly payments lowered and simplified, but be mindful of the long-term future. Consider how debt consolidation might affect your credit, whether you're subject to changing interest rates over time or if any new loan you take out has a specific repayment period that you must meet. If you're considering a balance transfer credit card, remain mindful of transfer fees, when any introductory interest periods end, and what your backup plan is should you overextend yourself.

Most Common Debt Consolidation Loan Requirements

• Proof of income. This is especially true if you don't have any collateral. This lets lenders know what you can afford to take on and informs how they might set things such as interest rates.
• Debt to credit ratio. If your debt is too high, it's possible that you won't be able to qualify for a consolidation loan.
• Creditworthiness. Lenders want to ensure you are a responsible borrower, so having a good credit score is essential in qualifying for a consolidation loan.
• Bank account information. Many lenders require you to have a bank account before they lend you money, so having one ready can be beneficial when applying for a debt consolidation loan.
• Proof of Identification. Lenders need to know to who they are lending money, so proof of identity is a standard requirement. Without the proper identification, the lender may be unable to approve you.

Debt Consolidation Alternatives

Budgeting

Getting out of debt doesn't always require tricky financial maneuvers. Sometimes, the best way to pay off debts is by reexamining your spending. Sometimes, it makes more sense to tighten a few belts and pay off original debts than to consolidate debt.

Cash-out Refinance

If you already have equity in a home on which you're making mortgage payments, you can get a cash-out to refinance. This is when you refinance your mortgage to pay off a larger total sum, but you receive cash from your home's equity now. You can use this cash for nearly anything, including paying off other debts. If you can refinance and pay lower interest than on other debts, a cash-out refinance may be a viable option.

Debt Settlement

With debt settlement, you're working with the original lender or creditor to come up with a lower amount they'll accept to settle your debt. Lenders might work with borrowers on a debt settlement as they may see this as safer than risking default, and they can receive a lump sum of a considerable amount. Debt settlement isn't all good for borrowers, though. It can affect your credit score for years, making it more challenging to secure loans or lines of credit in the future.

Consolidate Your Business Debt

If you're a business owner struggling with debt, consolidation can be the answer to helping you get back on track. Not only does it help free up cash flow, but it also allows you to better manage your payments each month.

A business loan can help you take control of your finances.

By choosing the right option for your situation, you can help ensure that you stay on top of payments and reduce your overall liabilities. If you want to consolidate your business debt, consider applying for a loan today. Apply For A Business Loan!