How does debt consolidation work?
Debt consolidation is the process of concentrating your debt payments into one monthly bill. Generally, there are 4 different types of debt consolidation.
Debt consolidation options
Option 1: Apply for a 0% interest, balance-transfer credit card. With the balance-transfer credit card, you can transfer all of your debts onto the card and pay off the balance during the promotional period of the card.
Option 2: Apply for a fixed-rate debt consolidation loan. With this loan, you can use the money from the loan to pay off debt. Then you would pay back the loan in monthly installments over a set period of time.
Option 3: Take out a home equity loan to pay off debts
Option 4: Take out a 401k loan.
Debt consolidation pros
Success with a consolidation strategy requires the following:
- Your total debt excluding mortgage doesn’t go beyond 40% of your gross income
- You have a plan to prevent running up debt again
- Your cash flow consistently covers payments toward your debt
- Your credit is good enough to qualify for a 0% credit card or low-interest debt consolidation loan
Say you possess four credit cards with interest rates ranging from 18.99% to 24.99%. You always make your payments on time, so you have good credit. You might qualify for an unsecured debt consolidation loan at 7% – a significantly lower interest rate. For most people, consolidation reveals a light at the end of the tunnel. If you take a loan with a three-yr term, you know it will be paid off in three years – assuming you make your repayments on time and deal with your spending. Conversely, making minimum payments on bank cards could mean a few months or years before they’re paid, all while accruing more interest than the initial principal.
Debt consolidation cons
Consolidation isn’t always the perfect solution for people with debt problems. It doesn’t address excessive spending habits that create debt in the first place. It’s also not the answer if you’re overwhelmed by financial debt and have no hope of having to pay it off even with reduced payments.
- When you consolidate, there’s no guarantee your interest rate will be lower.
- If your debt load is small – you can pay it off within six months to a yr at your current pace – and you’d save only a negligible amount by consolidating, don’t bother.
- Try a do-it-yourself debt payoff method instead, such as the debt snowball or financial debt avalanche.
- If the total of your debts is more than half your income, and the calculator above reveals that debt consolidation reduction is not your best option, you’re better off searching for debt relief than treading water.
- The debt consolidation loan interest rate is usually established at the discretion of the lender or creditor and depends on your past payment behavior and credit score.
- Even if you be eligible for a loan with low interest, there’s no assurance the rate will stay low. But let’s be honest: Your interest isn’t the main problem. Your spending behaviors are the problem.
- Lower interest rates on debt consolidation reduction loans can change.
- This specifically applies to consolidate debt through credit card balance transfers. The enticingly low-interest rate is normally an introductory promotion and applies for a specific period of time only. The rate will eventually go up.
- Be on guard for “special” low-interest deals before or after the holidays. Some companies know holiday buyers who don’t stick to a budget tend to overspend then panic when the bills start coming in.
- And other loan companies will hook you with a low interest then inflate the interest rate over time, leaving you with more debt!
- Consolidating your expenses means you’ll be in debt longer.
- In almost every case, you’ll have got lower payments because the term of your loan is prolonged. Extended terms mean extended obligations. No thanks! Your goal should be to get out of debt as fast as you possibly can!
Debt consolidation vs. debt settlement?
There is a big difference between debt consolidation and debt settlement, although often the terms are used interchangeably. Debt settlement means you hire a business to negotiate a lump-sum payment with your creditors for less than what you owe currently. In the case of debt settlement, these companies will also charge a fee due to their level of “service.” The kicker is that their fee can range from 15-20% of your debt.