It is more difficult to pay off your debt when you have debt from various financial institutions instead of just one. Deciding which one to pay first and dealing with multiple interest rates can increase the pressure on the debtor, making the situation worse. Thankfully, debt consolidation can help ease repayment terms for a debtor.
What is a debt consolidation loan?
A debt consolidation loan combines all eligible debts into a single loan. Instead of making payments directly to each creditor, you’ll only need to pay for the debt consolidation loan.
A debt consolidation loan is issued in two ways. Either the financial institution lends you the money you need to pay each debt or they pay the creditors you both agree to pay off.
Why have your debts consolidated?
Plenty of people choose to consolidate their debts because of the following benefits:
It’s easier to manage one debt instead of handling two or more. You can expect less pressure on your side as you deal with only one payment deadline each month.
Lower interest rate
Having multiple high-interest debts can easily add up in high costs. A consolidation loan can provide you with a lower interest rate that can help you save money. You can use this saved money to pay off your debt instead.
Improve your credit score
A bad credit score can affect your life more than you think. Loan and employment applications may be denied, you’ll acquire high-interest rates on loans and credit cards, and getting a house or a car will be difficult.
Debt consolidation makes it easier to pay on time each month therefore as long as you continue to stay on top of each payment you may start seeing improvements on your credit score.
Which debts can be consolidated?
Not all debts are eligible for consolidation. A financial institution may only allow you to consolidate the following types of debts:
- Credit cards
- Department store cards
- Utility bills
- Medical bills
- Income taxes
- Consumer loans
How are interest rates determined?
Interest rates are determined by the bank or finance company you’ll be borrowing money from. It depends on the credit score and the collateral you present. Your credit score reflects how likely you’ll be able to pay off the loan while collateral is something of value that can be forfeited in case you are not able to fulfill the agreement. An example of good collateral is real estate or a new car. The better the collateral, the lower the interest can get.
When borrowing money, you’ll want to look for a low-interest rate because this will determine how much money you’ll be charged on top of the original amount you borrowed. However, when you have a low credit score, you’ll most likely end up with a high-interest rate even if you offer good collateral. But if you have a high credit score, you might be eligible for a low-interest rate even without collateral.
What is the disadvantage of debt consolidation?
Once a person has all their debts consolidated into one loan, it’s possible to feel a false sense of security. It’s easy to think that they have finally settled their debts especially when the monthly payment for the loan is lower than the total amount of what they used to pay to various creditors. Now that they only have one big debt to worry about, they should avoid accumulating more. If a person doesn’t learn how to spend below their means and fails to make payments on time, their financial situation can end up worse than their situation before getting the loan.
Are there other ways to consolidate debts?
Debt can be consolidated through a number of different ways aside from a debt consolidation loan. Here are some examples:
Home equity loan
Let’s say you’re buying a house. If you buy your house using your own money, then that means you alone own the house. However, if you borrowed some money to buy your house, you only get to genuinely own the house once the debt is paid off. The money you still owe means that the lender still has an interest in your property. And the part of the house that you have already paid off to the lender is also called home equity.
Once you have a good amount of equity, you can be eligible for home equity loans. To do this, apply for a loan from the lender. The lender will then appraise your house and offer the maximum amount you can borrow.
Home equity loans are quite easy to obtain because your house is used as collateral. And usually, this type of loan only has low interest rates when processed through a normal bank or credit union.
Line of credit
If you choose to use a line of credit, you can borrow money from a bank or a credit company to pay off all your debts. Usually, you’ll need to offer collateral, however, if you have a good credit score, they may allow you to borrow an unsecured line of credit.
Credit card balance transfer
Take advantage of a credit card balance transfer by transferring your debts onto a new card that offers a low-interest rate (if not zero percent). The catch is that you have to pay off as much debt as you can before the promo period ends because after that the interest rate considerably racks up and you can end up with a much higher debt than you originally had.
Borrowing money from a family member or a friend is the best option if you have a bad credit score. Negotiate the terms and put it in a contract to avoid conflict. You have to make sure that you’ll pay as agreed unless you want to jeopardize your relationship with that person.
The effectiveness of debt consolidation as a means to get out of being in debt still depends on how willing you are to adjust to your financial situation. Ensure that you’ll be able to comply with the terms you agreed on by living below your means and sticking to your monthly budget. Also, avoid making any unnecessary purchases that can add to your debt while you’re still paying it off. In the end, it’s you who will benefit more than anyone else once you have finally paid off your debts.