People with considerable debt often wonder “is debt consolidation a good idea?”
Debt consolidation works by reorganizing multiple bills in the bank and rolling them into one payment. It’s a common strategy for becoming debt-free from student loans, credit card debt, and multiple debts. When done correctly, debt consolidation can bring down the interest rates and help you pay off your debts faster. For many people, it’s a smart personal finance choice.
Is debt consolidation a good idea for you? It depends on the type of debt you have. your repayment terms, and, what type of consumers are you. Don’t forget to reconsider your choice by asking about the application process you need to do.
Read on to find out more about when the consolidated loan is a wise decision.
Personal Loan
Consolidating debt with a
personal loan involves using the proceeds to pay off each loan. Use the money from the loan to pay off all of your debt. Then pay back the loan in installments over a set term.
Consider this method of consolidation if the personal loan has a lower interest rate than your current debts Otherwise, you will wind up paying more money over time. Don’t forget to always check on services and the limit to consolidating your debt with a personal loan.
Balance Transfer Credit Card
With a
balance transfer credit card, qualified borrowers typically get access to a 0% introductory APR for a period (six months to two years) The borrower can identify the balances they want to transfer when opening the card or after the provider issues the card. This is a great option if you can pay off the credit card during the 0% APR period.
Otherwise, you are likely to be stuck with very high-interest rates. This makes paying off the debt more difficult and very expensive.
Home Equity Line of Credit
If you are a homeowner you can
build equity on your home as you pay off the mortgage. Once you have equity on your home, you can pull out a home equity line of credit or HELOC. A
HELOC essentially serves as a revolving line of credit based on your home’s equity and, similar to credit cards, lets you draw on the funds you need. However, a home equity loan is a form of secured debt secured by your home.
A HELOC loan is a bit of a gamble because this type of credit is given based on the equity in your home. That means if you tap into this equity and your house does not appreciate or drops in value, or your home selling costs far outweigh the equity in your home, leaving you in more debt than you started with.
401K Loan
If you have a 401K retirement plan, you can borrow money against yourself. With fees and penalties, you can borrow a percentage of the money you have saved and pay yourself back with interest. There is a risk because you will lose money paying fees and taxes for prematurely taking money out of your 401K.
If your financial situation changes for any reason, like an emergency, you are still responsible for paying the loan back. The interest rate is typically lower than the rate on a personal loan.
Pros of Consolidating Debt
Consolidating your debt can have its advantages,
like streamlining debt, lowering interest and payments, as well as getting out of debt faster.
Reduce Monthly Payment
When overwhelmed with debt, most people are looking to lower their monthly payments.
Consolidating debt can lower overall monthly payments because future payments are spread out over a new and extended loan term.
While this can benefit you from a monthly budgeting standpoint, it means that you could pay more over the life of the loan. This may be true even with a lower interest rate. It applies if your current wages and income can cover your monthly debt service.
Improve Credit Score
Applying for a new loan may result in a temporary dip in your credit score because of the credit inquiry. However, debt consolidation can also
improve your score in many ways.
Paying off revolving lines of credit, like credit cards, can reduce the credit utilization rate reflected in your credit report. Making consistent, on-time payments can also improve your score over time.
Streamline Finances
Owing on several different loans or credit cards can feel extremely daunting to some, so combining multiple outstanding debts into a single loan reduces the number of payments and interest rates you have to worry about. Streamlining finances can also improve your credit by reducing the chances of making late or missed payments.
Quicker Payoff
If your debt consolidation loan is accruing less interest than the loans you are consolidating would, consolidation may be wise. It’s ideal when you can afford to make extra payments as you pay off the debt earlier, saving even more on interest in the long run.
However, most consolidation loan terms are for extended periods to make payments more affordable, so if you aren’t able to pay a little more each month, you will probably be paying for longer. You can also borrow more or against the value of an asset if you choose to use a secured loan.
When you did it right,
debt consolidation can lower the interest rates that you are paying on each individual loan and help you pay your debts faster.
Lower Interest Rates
If your
credit score has improved since applying for other loans or lines of credit, you may be able to decrease your overall interest rate with consolidation. By doing so, you can save your money over the life of the loan, especially if you opt for a short loan term.
Consolidating your loans with a loan that has a higher interest rate will just hurt you in the long run. A higher interest rate costs you more money and debt over time. Shop around for the lowest rates possible when looking for a consolidation loan or line of credit.
Cons of Debt Consolidation
A
debt consolidation loan or credit card isn’t always the best option when trying to consolidate debt. In some cases, either of these options can cost you more money or debt than you started in the first place.
Added Costs
If your credit score isn’t high enough to access the most competitive interest rates, you may be stuck with a rate that’s higher than on your current debts. This may mean paying origination fees, plus more in interest over the life of the loan.
Also, pay attention to the fine print. You don’t want to get stuck with large annual fees either. Check on with current lenders if there are added costs.
High-Interest Rates
Even if your interest rate goes down when consolidating, you could still pay more in interest over the life of the new loan. You pay more in interest if the repayment timeline exceeds the amount of debt. Consolidating debt can be tempting thanks to the convenience of one monthly payment. However, if your consolidation loan doesn’t have a lower interest rate, the convenience is not worth the cost overall.
Underlying Issues
Consolidating debt is a good step toward financial responsibility. However, consolidation alone does not solve the issues that may have gotten you in a financial bind in the first place.
Many borrowers who take advantage of debt consolidation find themselves in deeper debt because they didn’t curb their spending. Instead of resolving their debt, they continued to build debt. So, if you’re considering debt consolidation to pay off multiple maxed-out credit cards, make sure to spend responsibly moving forward.
Missing payments on a debt consolidation loan will cause major damage to your credit score. Missing payments may also subject you to added fees. Avoid this by going over your budget with a fine-tooth comb to ensure you can comfortably cover the new payment. Consider taking advantage of autopay or any other tools that can help you avoid missed payments and fees.
It’s easy for borrowers to fall into the vicious cycle of paying off debt just to run up balances on credit cards once again. Evaluate old spending habits. Try to break them by budgeting accordingly and not using the credit lines you are paying down.
Is Debt Consolidation Right For You?
The most important thing to keep in mind with
debt consolidation is that it does not lower how much debt you owe. It simply moves your debt from one place to another, ideally under more favorable terms.
Debt consolidation might be right for you if you have a large amount of debt, good credit, income that can cover monthly debts, a plan to improve spending habits, good payment history, and good credit history. Debt consolidation has many benefits, like lowering monthly payments. It may reduce the time you pay on a loan and make payments more convenient by combining them.
However, those benefits don’t apply to everyone. You must research the content of debt consolidation and decide what’s best for your unique financial situation.
