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All There is to Know About Debt Consolidation

debt consolidation

Credit Sesame’s guide to all there is to know about debt consolidation

Having outstanding unpaid debt can be stressful, especially if you have multiple debts owed to different creditors. One strategy for getting out of debt is pursuing debt consolidation, in which you use a debt consolidation loan to bundle several debts into one and make a solitary payment.

Prior to choosing debt consolidation, learn the facts, weigh the advantages and disadvantages, determine what’s involved, and consider alternatives.

What is debt consolidation?

Perhaps you have multiple outstanding balances due to different creditors, including credit card companies, personal loan lenders, and retail accounts. Having various creditors to pay off can be challenging and confusing. There’s always the risk of forgetting to pay one or more of these companies, which can hurt your credit and result in paying extra fees or penalties assessed.

With debt consolidation, you take out a new loan to repay your outstanding debts, thereby simplifying the payment process. Any unpaid debts you choose can be rolled into this new loan.

Debt consolidation loans are offered by various lenders, including banks, credit unions, and installment loan lenders.

Pros and cons of debt consolidation

Instead of making numerous payments each month, you’ll only have to make one payment on your new debt consolidation loan. This is the main advantage of going this route.

Additionally, a debt consolidation lender may offer an introductory interest rate that is lower and more attractive than the interest rates you currently pay for your credit cards or loans you want to be consolidated. However, many of these introductory rates are considered “teaser rates” that expire after a particular time. After the teaser rate ends, your lender may charge a higher rate.

Depending on the term of the debt consolidation loan you choose, your monthly payment might be lower than the combined monthly payments on the loans and debts you are currently paying. Put another way, your monthly payments may be more affordable, especially if you have a long repayment period. But chances are that you may pay more in total interest, principal, and fees for the debt consolidation loan than if you had not opted for a debt consolidation loan.

That’s why it’s wise to carefully compare interest rates and loan terms to determine how much interest and fees you’ll pay in total. Doing so can help you select the right debt consolidation loan for your needs and budget.

Keep in mind that a debt consolidation loan will not erase your debts. You are still responsible for completely repaying what you owe on any loans and debts you consolidate.

Also, while a debt consolidation loan can make it easier to manage your debt repayment, if you continue to make additional purchases using new or existing credit, you likely won’t succeed in paying down your debt efficiently. In fact, without financial discipline, you could create a more significant debt problem that can ruin your credit.

Lastly, be aware that if your debt problems have impacted your credit score, you probably won’t qualify for lower interest rates on a debt consolidation loan or alternative form of debt consolidation (more on alternatives later).

Who is debt consolidation best for?

Debt consolidation doesn’t offer a magic bullet cure for getting out of debt. But it can be a good choice for those who can continue to afford to repay their monthly debt obligations but who are seeking a more straightforward “one-payment” strategy that can eliminate having to make multiple payments every month.

The key determinant here is your ability to make the new monthly payments on time and in full. If you don’t stick to the plan and the monthly deadlines, debt consolidation can backfire, resulting in more outstanding debt and damaged credit.

Additionally, debt consolidation may not be your best choice if a new debt consolidation loan doesn’t provide a lower interest rate than the rates you are currently being charged. If most or all of your debts come from credit cards, chances are that the interest rates your credit cards will charge will be much higher than the rate a debt consolidation loan can offer.

If your credit score is relatively low, debt consolidation may not be the best option. That’s because a debt consolidation lender may charge a higher interest rate if your score is low.

Alternatives to a debt consolidation loan

A debt consolidation loan from a lender, credit union, or other financial institution isn’t your only choice. If you are determined to consolidate your debts into one payment, you can instead pursue a:

  • Home equity loan. Also called a “second mortgage,” this loan allows you to borrow against your home’s equity. According to the Federal Trade Commission (FTC), you obtain the loan for a particular amount of money that must be repaid over a set period; you usually repay the loan with equal monthly payments over a fixed term. But this option can be risky because if you fail to repay the home equity loan, your property could be lost to foreclosure. You may also be required to pay expensive closing costs, too.
  • Home equity line of credit (HELOC). Like a credit card, this is a revolving line of credit. Per the FTC, a HELOC lender approves you for a specific amount of credit; so long as you remain below that credit limit, you can borrow as much as you require whenever you need it. Many HELOCs have an initial “draw period” when you are allowed to borrow from the account. Following this period, you may be able to renew the credit line; but if not, you will likely be required to begin repaying the amount due. HELOCs typically offer variable interest rates and payments. Like a home equity loan, a HELOC uses your residence as collateral, meaning you can lose your home to foreclosure if you don’t repay the HELOC on time.
  • Credit card balance transfer. Some credit card issuers offer a zero-percent or low-interest balance transfer option to entice you to consolidate your debt via one new credit card. However, be forewarned that the promotional interest rate generally lasts for a limited time only, after which the rate can rise significantly. You may also have to pay a balance transfer fee, calculated as a fixed amount or a particular percentage of the amount you transfer.
  • Debt management plan (DMP). A DMP, offered by a nonprofit credit counseling agency, enables you to merge your unsecured debts into a sole monthly payment. The agency will attempt to negotiate more affordable repayment plans with your creditors.

Before committing to debt consolidation

The Consumer Financial Protection Bureau (CFP) cautions that due diligence is required before taking out a debt consolidation loan of any kind. They offer the following tips:

  • Review your spending carefully. It’s essential to comprehend why you are in debt. If you’ve amassed significant debt due to poor financial habits and spending beyond what you earn, a debt consolidation loan likely won’t aid you in climbing out of debt unless you make more money or decrease your spending.
  • Devise a workable budget. Calculate if you can pay off your existing debt by altering your spending habits over a specific period of time.
  • Remember that any loan you open for the purpose of consolidating your debt could result in you paying more in the long run via higher interest rates, fees, and unexpected costs than if you had merely repaid your previous debt payments.
  • Attempt to contact your individual creditors and inquire if they will agree to decrease your payments. Some creditors could be amenable to receiving lower minimum monthly payments; or they may agree to lower your interest rate, waive particular fees, or amend your monthly due date to better correspond to when you get paid – steps that can help you repay your outstanding debt.

Action steps involved

Still determined to seek a loan for debt consolidation? Follow these recommended steps:

  • Review your credit reports. Visit Annualcreditreport.com to access your three credit reports (from Equifax, TransUnion, and Experian) for no charge. Look over each report for errors or inconsistencies and work to resolve these with the creditors involved.
  • Review and improve your credit score. Your bank, credit card, or mortgage lender may offer access to your credit score for free online or upon request. If your score is in the 600s or lower, work to improve your score by making timely debt payments, not opening any new credit accounts, and avoiding closing existing credit accounts.
  • Shop around for a debt consolidation loan or alternative loan carefully. Request rate quotes and loan packages from different lenders and compare rates and terms to choose the best deal. Be sure to learn what the total cost of the loan will be (principal plus interest plus fees).
  • Aim to remain financially disciplined. Create a budget that works for your finances, create reminders about your monthly debt payment due date, and don’t overspend beyond your means.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

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Published August 12, 2022
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