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Debt consolidation can be a huge advantage to folks working to pay off their debt.
But it does have some risks and can be a nightmare causing more damage than good for those that go into for the wrong reasons.
In this article, we’ll discuss:
- what it means to consolidate your debt
- who debt consolidation would be good for
- who should run as far away from a debt consolidation as they can, and,
- how to make sure you stay on the right track it’s right for you.
What’s debt consolidation?
Debt consolidation is getting your debts down from multiple payments, into one monthly payment.
This usually involves getting a new loan at better terms (refinancing) to pay off the other smaller loans (freeing you of those loan payments) and leaving you with one monthly payment for the new ‘bigger’ loan.
What are the advantages of debt consolidation?
There are quite a few benefits that come with debt consolidation
- The opportunity to simplify your payments down to one monthly payment – It can be confusing keeping track of multiple due dates in a month
- With multiple smaller payments, it’s hard to see your debt paydown progress – Having one loan and one payment allows you to concentrate your efforts in one place
- You get a boost to your credit score for paying off the ‘old loans’ even though you open a new loan.
- Opening a consolidation loan and zeroing the balance on credit cards boosts your score as you benefit from lower credit utilization and credit mix
- Getting access to better interest rates – Loans with a fixed period of time usually carry better interest rates than credit cards, and if you use a HEL (Home Equity Loan) then your rates are even lower because it’s secured debt.
- With lower interest rates, minimum payments can be lower since you are paying less in interest every month and more towards the debt. That’s extra savings in your pocket every single month
- Better savings overall – with lowered interest rates, you are paying less for the loan over the course of the term. More money saved all around
What are the risks of debt consolidation?
Even though debt consolidation comes with some life-changing advantages it can be dangerous if you take it without it being a good fit for you.
Here are some things to be aware of:
- Debt consolidation doesn’t fix the problem – You had debt before, you still have debt now.
Debt consolidation HELPS YOU to fix the problem. You still have to make monthly payments etc.
- It’s tempting to start spending on credit again – Seeing a clean credit card after the consolidation is amazing. The weight of the credit card is lifted off your shoulders and you feel like you are debt-free.
And it can be incredibly tempting to slowly start making purchases on the card again getting yourself in a worse situation, maxed out credit cards AND a consolidation loan
- If you consolidate using a home equity loan then you are putting your property at risk by taking unsecured debt and turning it into secured debt.
If you have credit card debt and don’t pay the bill you get collection agencies calling. you take out a home equity loan and don’t pay the bill and you get foreclosed on and evicted. That’s much worse.
Debt consolidation is right for you if:
- You already have a plan for paying off debt and just need some extra help
Debt consolidation makes the terms better and makes your payments more effective at paying down the debt. But you need a plan first and it’s even better if you have been working it for some time and are already in the habit of debt paydown.
- You’ve stopped using your credit cards
The only way consolidations work for your benefit is to stop using your credit. If you are continuing to rack up debt, then consolidation won’t help you.
- You have good credit
Having a good credit score makes you a less risky borrower and so lenders are much more likely to give you favorable rates. Unfortunately, those with a significant debt problem usually have
- Your interest rates on your current debt are high enough where a change in terms can help
If you have a 6% interest rate, then debt consolidation may not be very beneficial. But if you have a 25% interest rate, then the benefits will be more substantial.
What options are there for a loan?
There are many ways to do debt consolidation. Here are some of the most common:
- Balance transfer credit cards
You can transfer the balance of other credit cards to one credit card and effectively complete a debt consolidation since you only need to pay back the one credit card.
I wrote a great article detailing what to look for specifically with balance transfers
- Consolidation loans
Banks, credit unions, and installment loan lenders may offer debt consolidation loans. These loans collect many of your debts into one loan payment.
Check out my favorite loan providers
- Home Equity Loans
With a home equity loan, you are borrowing against the equity in your home to pay off your current credit cards. Not a bad option, but I hate the idea of backing up debt with your house.
Bad things happen all the time, and I’d rather have a house and debt than be homeless and ‘kinda’ debt-free.
- 401k Loan
You can take a loan out against your 401k retirement account to pay off your credit cards, and then repay the 401k loan back. Note: I list this as an option but it is not one I recommend unless if the direst circumstances because it messes with your retirement and if you can’t pay it back, then you end up with a bunch of taxes and penalties.
How do I consolidate my debt?
When deciding to consolidate your debt the first place you start is with your current debt.
Gather the following details about your debt
- who you owe
- how much you owe
- what are the minimum payments
- the interest rate on each of the debts
- when they are due and,
- the date they are all due.
Pull your credit score
You also want to pull your credit score. You can use Credit Karma to get a free copy of your score. Having that ready in hand makes it easy to get loan options.
You can ask banks and credit unions what their rates are with your credit score and get a general idea of what’s possible.
You can also check with online lenders who usually have better rates and can check your rate (without pulling your credit score) and give you an estimate in just a few seconds. Credible and Payoff are two companies that offer this online service without impacting your credit.
In fact, Credible checks with multiple lenders and presents the best deal to you, and you only have to fill out the forms one time.
Do the math
Once you’ve got a few offers under your belt, now it’s time to work the numbers.
Use a financial calculator (you can find one easily by googling) and inputting the new loan amount, interest rate and timeframe to find out how much you would be paying out in interest over the course of the loan.
Also, use the financial calculator to compare how much interest you would pay over the course of your current loan so you can see if the savings are worth it.
Comparing the monthly payments as well can be helpful in determining the monthly savings, and also to ensure you can pay back the new loan each month.
While the goal is to get the best rates (lowest interest rate for the shortest period of time) don’t go overboard. You don’t want to get too aggressive with paying off your debt and be unable to make the monthly payments.
Commit to the plan
Once you’ve picked your best option and done the math then it’s time to get the loan and commit to the plan.
You may be savings more every month, but don’t relax on your debt payment. You still want to get it out the door quickly, just in a sustainable manner.
Don’t lose the energy for paying off the debt, or start back into your spending.
Consolidation is a strategy to achieve your future goals so remember the plan.