Having too many debt balances to pay off can be a serious financial challenge, especially when you have a low income. To become debt-free, you may have to resort to debt consolidation—taking out a new loan or credit line to pay down other existing balances. This way, you have combined all your previous debts into a single loan.
Debt consolidation is actually one of the several debt payoff strategies you can employ to pay off your debt. Since you are interested in learning how this method works, this post will show you exactly how to consolidate your debts. With the vivid example explained below, you’ll realize that this is a simple and straightforward strategy that can help you become debt-free soon.
What Is Debt Consolidation?
Debt consolidation is a debt payoff method that works by combining all your existing debt into a single loan. For example, your credit cards, auto loans, and student debt can be consolidated into a single debt balance with favorable payoff terms that alleviate the burden of debt payment.
Is It A Good Idea To Consolidate Your Debts?
Debt consolidation is usually one of the last options you should consider when trying to become debt-free. It may not be an ideal solution for every household, especially if they have several high-interest loans.
However, if after analyzing your debt situation carefully, you realize you can’t keep up with the monthly debt payments, then it’s a good idea to resort to debt consolidation.
How Does A Debt Consolidation Work
Debt consolidation works by combining your various debt balances into a single loan. Then, you won’t have to worry about making different debt payments every month. All your payments will be streamlined into one balance.
Depending on the terms of the new loan you take to consolidate your debt, you can improve your credit score, reduce your monthly payment, and even become debt-free sooner.
You must understand that there are a number of ways to roll over existing debts into new debt, such as getting a home equity loan, a new credit card with a high credit limit, or a new personal loan. Then, you are expected to use the new loan to settle your earlier, smaller debts.
For instance, it’s ideal to move the balances from your old credit card to your new one—if you are using the new card to pay off existing credit card debt. Some credit cards that facilitate balance transfers also provide a few perks, like a temporary 0% interest rate on the transferred amount.
Debt consolidation can help you simplify your finances by reducing the number of bills you have to pay each month and the number of deadlines you have to keep in mind. It can also help to lower interest rates and monthly payments.
An Example Of Debt Consolidation
Let’s assume you have three credit cards with a combined debt of $30,000 and an average yearly interest rate of 25.55%. To pay off the balances, you would have to pay around $1,569 every month for a total of 24 months—bringing the balance to zero.
Now if those three credit lines are combined into a single credit card with lower interest—let’s say 10%. This means you’ll pay $1,375 each month. Apparently, you will spend less money clearing this single debt balance since the interest rate is lower. This is one of the main benefits of debt consolidation.
Pros And Cons Of Debt Consolidation
Consolidating your debt can have a number of benefits and disadvantages. It’s important you understand these vital things before you take out one big loan to combine your debt balances. Here are the pros and cons of debt consolidation you need to be aware of:
[Pros]
- May Help You Pay Off Faster
Consider using the additional money you save each month to make extra payments on your debt consolidation loan, if the interest rate is lower than it would be on the individual loans. This can assist you greatly in paying off the debt sooner, which will ultimately result in even bigger interest savings.
However, keep in mind that debt consolidation usually results in longer loan terms, so in order to benefit from this, you must make it a point to pay off your debt as soon as possible.
- Will Help You Streamline Your Finances
This is one of the pros of debt consolidation. You can lower your interest rates and number of monthly payments by consolidating several existing loans into a single loan. By reducing the likelihood of missing or making a late payment, consolidation can also help you build a better credit score. Besides, you’ll know more precisely when your balances will be paid off if you aim to get out of debt completely.
- Will Help You Spend Less On Interest Rate
Even if you already have low-interest loans, you might be able to lower your total interest rate by consolidating debt, as long as your credit score has increased since you applied for other loans. If you don’t consolidate with a long-term loan, doing this can save you money over the course of the loan.
Make sure you ask around and find lenders who provide a personal loan prequalification process in order to secure the best available rate.
But keep in mind that different types of debt have different interest rates. For instance, the rates on credit cards are typically higher than those on student loans. So when you consolidate your debts, the interest rate may be higher than some of your individual loans and lower than others.
- Will Reduce Monthly Payments
Your total monthly payment will likely decrease when you consolidate your debt. The primary reason is that subsequent payments are spread out over a longer loan term. Although you’ll benefit from a reduced interest rate, particularly in terms of a monthly payment, this could result in you paying more for the loan in total.
- Will Improve Your Credit Score
Your credit score can temporarily drop if you apply for a new loan because of the harsh credit investigation. But there are also several ways that debt reduction might raise your credit score.
For example, when you successfully pay off credit cards and other revolving lines of credit, you can lower the credit usage rate shown on your credit report.
Ideally, your utilization rate should be less than 30%, and you can achieve that by carefully combining your debt. Over time, you can also raise your credit score by paying off the loan and maintaining a consistent, on-time payment schedule. This is one of the pros of debt consolidation.
[Cons]
- May Come With Added Costs
Even though paying off debt with this method is expected to save you money, it doesn’t work that way all the time. Additional costs such as balance transfer fees, origination fees, and annual fees may be incurred while taking out a debt consolidation loan. Hence, before signing on the dotted line, make sure you are aware of what a debt consolidation loan would cost you.
- You May Pay More In Interest
Now this is the shocking part that most people aren’t prepared for. You may still end up paying more in interest over the course of the new loan, even if your interest rate drops when you consolidate.
The payback period for debt consolidation begins on the first day of the repayment plan and can last up to seven years. Although the total amount you pay each month could be less than you’re used to, interest will accrue over a longer time frame. It’s one of the cons of debt consolidation.
As a result of this, I recommend setting aside money each month for payments over the minimum required by the loan. This is the only way you can profit from a debt consolidation loan without having to pay extra interest.
- You Could Miss Some Payments
When you fail to make on-time payments on any loan, including a debt consolidation loan, this would result in additional costs and can also seriously harm your credit score. This is why it’s important to always examine your spending plan to make sure you can afford the additional payment. That’s how you avoid this.
On the other hand, you can make use of autopay or any other methods available to you to help prevent missing payments once you have consolidated your debts.
Also, let your lender know as soon as possible if you ever feel you might miss a payment. They may decide not to charge you an extra fee for the late payment.
- Your Spending May Increase
In a similar vein, using a debt consolidation loan to pay off credit cards and other lines of credit may give the impression that you have more money than you actually do. Borrowers frequently find themselves in the trap of paying off before discovering that their balances have increased once more.
Create a budget to control your spending and ensure that you pay your bills on time to avoid taking on additional debt.
- Underlying Financial Issues May Not Be Resolved
While debt consolidation can make payments easier, it doesn’t change the underlying financial behaviors that caused the debts in the first place.
Here’s the thing—a lot of borrowers who benefit from debt consolidation end up with more debt because they didn’t cut back on their spending and they also allowed their debt to accumulate. Considering this, it’s important to practice and develop good money habits before considering debt consolidation as a way to pay off several credit cards you’ve maxed out.
When Should I Consolidate My Debt?
Since debt consolidation is usually one of the last options to consider, it’s wise to carefully assess your financial situation before you go on to consolidate debt.
Want to know when it’s the best time to use this payoff method? Here are the things you must first do:
Seek Assistance From A Nonprofit Credit Counselor
You can find help and make better decisions concerning your debt payoff plan. There are several credit counseling organizations that will advise you on how to manage your money and become debt-free (for free). Eventually, you may realize you never needed to resort to debt consolidation.
Find Out Why You Are Stuck In Debt
Until you clearly understand the reason you are in debt, don’t bother looking for a solution.
For example, if you have several debt balances because of your bad spending habits, then debt consolidation may not even help you. The solution to your problem is obvious—drastically reduce your spending.
You either reduce your spending to match your income or increase your income to match your spending. Otherwise, you are simply living beyond your means, and that will result in more debt.
Create A Budget
If you haven’t been budgeting your salary every month, you are doing the wrong thing. Using the right budget method to organize your expenses and track your spending could be the key to getting out of debt.
Reach Out To Your Creditors To Negotiate Lower Payments
To help you pay off your debt, some creditors might agree to reduce the minimum payments you are expected to make every month. They may also be willing to waive certain fees, lower your interest rate, or fix a new monthly due date to match your payday.
Final Thoughts On How To Debt Consolidation
Taking on a new debt to pay off old debts may not be the best solution. Unless you cut back on your expenses, you may fail to pay off your debt by taking on more debt. Besides, to be eligible for debt consolidation or have your interest rates reduced, you must have a healthy credit score.
More importantly, promotions for debt consolidation plans that seem too good to be true should be avoided. Many organizations that promote consolidation services can actually be debt settlement firms, which sometimes demand upfront payments in exchange for their guarantee of debt settlement. They might also persuade you to move money into a designated account in place of paying off your debts.
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