What is a debt consolidation

What is a debt consolidation? Is it convenient? Here are things to know

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In the United States, it is common to have several debts with different financial entities. Each of these debts is subject to interest rates, maturities, and various charges. This makes paying each one separately very tedious, which is why there is something called debt consolidation that allows you to unify all your debts into a single invoice.

In addition, consolidating debt also allows you to reduce a little the amount of money that you will end up paying. Yes, believe it or not, a well planned and executed debt consolidation can be your ticket to a comprehensive improvement of your economy.

Here in this article, you will learn everything you need to know about debt consolidation: the types that exist, their benefits, their negative sides and, if you continue reading, you will be able to know if a debt consolidation is really the right move for you at this time.

What is debt consolidation?

Debt consolidation is merging multiple debts into one. Instead of making separate monthly payments to multiple creditors (lenders, banks, etc.), you bundle them into one payment from a single lender, ideally at a lower interest rate.

Although debt consolidation will not cancel your debts or reduce the amounts you owe, it is a strategy that many uses to make paying them easier and cheaper.

If you have debts of various types, you can use debt consolidation to merge the payment of all of them into one.

Debt Consolidation Forms

debt consolidation form

Balance Transfer Credit Cards

Some credit card companies allow you to transfer your higher interest balance to a new card with 0% interest or another interest rate that will allow you to pay off the entire balance at this new lower rate but in a shorter period of time. By paying off your debt within the limited time period, you can save a lot of money.

However, there are some issues that you should take into account before deciding on this debt consolidation option:

Balance transfer fees: Many companies charge a balance transfer fee, often between 3% and 5% of the total amount transferred. If the fee is high enough, it could negate the benefits of doing a balance transfer.

Short promotional period: The time you have to pay off your balance with the introductory balance transfer rate is fairly short, often between nine and 21 months. After that, your interest rate will increase, so you’ll have to pay a lot more in interest from then on. If you can’t pay off your balance within the introductory period, then you could end up with the same high-interest rate you were trying to escape.

Home Equity Loans and Lines of Credit

If you own a home, you could take out a loan against your equity to consolidate debt. This is commonly known by its English name as Home Equity Line Of Credit (HELOC)The amount you can borrow will be limited by the equity you have, basically the value of your property minus the outstanding balance on your mortgage, and other factors. Generally, the available value is enough to pay off your debt.

Because the loan is secured by your home, you can usually qualify for a lower interest rate than other debt consolidation methods.

However, using a home equity loan can be risky. Since your home serves as collateral to secure the loan, you could end up losing your home if you fall behind on your payments.

 

401(k) loans

If your employer offers a 401(k) retirement savings plan, you can choose to allow participants to borrow from their accounts, although not all plans allow this. Borrowing from your own 401(k) doesn’t require a credit check, so it shouldn’t affect your credit.

As long as you have a vested account balance in your 401(k), and if your plan allows loans, you’ll likely be allowed to borrow against it. Just like any other loan, you’ll have to pay off a loan from your 401(k) with interest within a certain period of time. 

Although 401(k) loans may seem like a great idea—why wouldn’t you rather borrow money yourself?—there are some big negatives to this plan beyond having to pay interest.

If you fall behind on your payments, the unpaid balance will count as a distribution. And if you’re not at least 50%, you could face a hefty tax bill for an early distribution on the amount you withdrew. Also, if you leave your job or are laid off, you may have to repay the loan in full right away.

From a long-term perspective, the money you withdraw loses its ability to grow. In the time it takes to repay the loan, you could miss out on market gains that might have boosted your retirement fund.

Personal loans

Another way to consolidate debt is to request a personal loan. However, this is only convenient when the personal loan has a good interest rate.

Interest rates on a personal loan depend on your credit health, income, and other factors. If you have poor credit, you may not qualify for a low-interest loan.

If you decide to use a personal loan for debt consolidation, use the money from your new loan to pay off the existing balances of all the debts you are consolidating. If you use a balance transfer credit card, you will transfer existing balances to the single credit card.

Make your new loan payments in a timely manner. Consider setting up automatic payments for this loan. Any extra money you earn put it toward paying off this new loan.

 

How can you benefit from debt consolidation?

Consolidating debt can help you manage your finances more effectively, saving you money on late fees, lowering the number of monthly payments, and reducing the amount of interest you’re paying.

The greater the difference between the current interest rates on your debts and the new rate on a consolidation loan, the greater your savings.

In the long run, if you can lower your total balance, you can also improve your credit score, since you’ll be lowering your credit utilization ratio.

When debt consolidation is a good idea

Debt consolidation makes sense when people are truly committed to reducing their overall debt and simplifying their finances by lowering their monthly payments. Borrowers with good credit scores often benefit the most from debt consolidation because they can get better interest rates.

Ideally, you should have a plan to prioritize payments on your new consolidation loan in order to pay it off as soon as possible. Creating a budget or spending plan can help ensure that you live within your means and avoid taking on new debt.

 

When debt consolidation is a bad idea

If the interest rate on your debt consolidation loan is higher than the rates on the loans you’re currently paying, you may not save money by consolidating debt. If you can’t get a loan at a rate that makes debt consolidation effective, consider other methods of paying off your debt.

Borrowers who don’t commit to reducing their debt over the long term won’t reap the full benefits of consolidation either. The reason? They may end up incurring new debt on the cards they just paid off, creating a spiral of debt that is difficult to break.

 

How to avoid accumulating more debt

Although debt consolidation can help you pay off high-interest debt, it’s not a magic bullet. If you’re looking for debt consolidation, you may need to make significant lifestyle changes to ensure that you don’t accumulate more debt and that your plan works.

  • Identify the root problem: Check your statements to see where you spend more. For example, you may find that you spend too much on eating out, or that you go shopping when you feel stressed. Once you address those root causes, you can make the appropriate adjustments. Look first for an internal solution.
  • Create a budget: A realistic budget and sticking to it is the next step after taking a hard look at your spending habits. It’s about setting limits and avoiding carrying credit card balances from month to month.
  • Stay focused: Paying off your debt in full can take months or even years. Review your account statements regularly to hold yourself accountable and stay on top of things. This will put your progress and financial goals first.

Analyze in depth each of the forms of debt consolidation that are presented to you and only then is when you must decide which one best suits your case. You don’t want to be surprised when you have to pay. Try to read the fine print and create a monthly spending plan to keep your finances healthy.

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