Every year, hundreds of thousands of Americans diligently search for ways to dig themselves out of debt. The sheer volume of information available online about debt relief can be overwhelming and hard to decipher. There are myriad experts and analysts who will dole out advice on the topic without knowing your unique circumstances; which is why we've put together a no-nonsense guide to debt consolidation that will help you to choose whether or not it is right for you.
Understanding Debt Consolidation
Debt consolidation is a way to roll credit card bills and other high-interest loans into one payment with a lower interest rate. It reorganizes and reduces your total debt, thus enabling you to pay it off at a faster rate. Debt consolidation is a sensible way to handle your bills, provided the total amount of your debt is manageable. Consumers who find themselves overwhelmed with multiple payments have the option of applying for a consolidation loan to funnel those debts into one single liability that can be paid off over time. This option essentially allows you to reorganize multiple balances with different due dates, payment amounts, and interest rates.
The majority of consumers seek this type of loan from a credit union, bank or credit card company. This is a good initial step, particularly if you have a strong payment history and a positive relationship with your institution.
It is essential to understand that debt consolidation loans do not eliminate debt, but rather roll it into a different type of loan (or place it with a different lender). If a person needs debt relief and does not qualify for a loan, the most practical course of action is to explore debt settlement options, or a debt consolidation loan in conjunction with a debt settlement plan.
Debt settlement refers to various plans for which the objective is to reduce the consumer’s debt liability, rather than the number of lenders he or she owes. Taking this option, the consumer works with credit counseling services or debt relief organizations. Debt relief organizations do not lend money, but rather negotiate with creditors on behalf of the consumer to eliminate or restructure as much debt as possible.
When to Start Thinking About Debt Consolidation
If your total debt is not more than half of your total income and your credit score is favorable enough to allow you to qualify for a credit card with 0% interest, debt consolidation may be exactly what you need. You should also consider reaching out to organizations that offer debt management plans to help you in the future.
Not surprisingly, you must also make sure you have adequate income to comfortably make your payments on a monthly basis, as well as an emergency plan if your financial situation changes or you somehow incur additional debt.
Virtually all debt consolidation programs work best when an underlying plan is in place to realistically lower the total amount of debt without placing your other assets in future peril, such as your home or car.
It is always wise to compare your gross yearly income with the total amount of your debt to determine whether or not the debt can be paid off over the next few years. A loan calculator is a helpful tool you can use to get a general estimate of your monthly payment amount.
Consolidating debt gives a ray of hope to many people, because it has definite terms. For example, if you take a three-year debt consolidation loan, you know that you have the possibility of being debt-free in that length of time, provided you manage your spending and make timely payments. In contrast, making only minimum payments on multiple loans–including credit cards–could mean years of interest, which may eventually exceed the initial principal.
When to Avoid Debt Consolidation
Consolidation does not address the issues that may have led to the debt in the first place, such as excessive spending habits. It is also not a good option if your debt has reached an amount that you know you cannot realistically expect to pay off, even with lowered payments.
On the flip side, if your debt is minimal and consists of balances that you know you can pay down in less than a year without changing anything, it doesn’t make much sense to consolidate, as you would only save a negligible amount. In this case, you would be better off trying another repayment method, such as debt avalanche, debt snowball or some other do-it-yourself payoff plan.
Finally, if your debt exceeds 50% of your income and it is determined that debt consolidation will not help, you should pursue debt relief options rather than spin your wheels trying to consolidate.
Financial circumstances vary significantly from one person to another, but in many cases, bill consolidation means you will be in debt for a longer length of time. This is because you are not eliminating debt, you are simply restructuring it to create lower payments by prolonging the loans and extending the terms.
It’s important to change your behavior and establish good money habits in addition to debt consolidation. This is because many people re-accrue debt after consolidating, as they have no solid plan to spend less and not put so much on credit.
If you haven’t established good money habits are not established, it's possible that you could find yourself in debt again in the future.
Types of Debt Consolidation
You have two major options with debt consolidation loans:
Secured loans backed by assets to use as collateral, such as a car or house.
Unsecured loans which do not require collateral backing.
Unsecured loans are a bit more difficult to obtain, as no collateral is needed. Lower qualifying amounts and higher interest rates are also characteristics of such loans. Nevertheless, whether the loan is secured or unsecured, the interest rate will likely be lower than that charged by most credit card companies. Additionally, debt consolidation loans typically offer fixed interest rates.
There are several ways to consolidate bills into a single payment, the following are the most common:
Debt consolidation loans designed specifically for individuals who have many high interest accounts that can be difficult to manage. Numerous creditors, including peer-to-peer lenders and banks offer consolidation plans for such consumers.
You may also wish to consider consolidating all your credit card payments with one, new credit card. If the new card has an introductory period during which you pay little or no interest, this may be an ideal option. Many cards offer this type of reduced interest specifically to customers who want to transfer balances.
A home equity line of credit–HELOC–or traditional home equity loan is an option if you have equity in your house.
If you have student loans, you should also look into consolidation programs offered by the federal government, in which the new interest rate is an average of the various rates of your previous loans. This type of consolidation is available through the Federal Direct Loan Program. However, it should be noted that this program is not for consolidating private loans.
Debt Consolidation Requirements
If you are approaching a new lender for a consolidation loan, you must be creditworthy and have the appropriate income for the loan you are seeking. In most cases, in addition to your credit report, you will have to provide proof of employment, several months worth of statements from the various loans you wish to consolidate, and letters from creditors.
Once you have qualified for a debt consolidation loan, consider whom to pay off first. Often, the lender makes this decision, but if it is up to you, make your first payments to your highest interest creditors first.
The Final Verdict
Consolidating debt can be an effective way to get your finances back on track, but only you can decide if a consolidation loan is right for you and your unique circumstances.