Have you found yourself overwhelmed or struggling to keep up with different debt payments each month? Or perhaps your interest rates are higher than average and costing you a ton of money?
If you answered yes to one or both questions, in situations like this debt consolidation might seem like an attractive option. However, it's important to understand how debt consolidation works and make sure that if you choose to use it, it's to your benefit!
It's also important to keep in mind that debt consolidation is not a solution to poor financial habits. You'll still need to address things like your money mindset, financial discipline, overspending, budgeting and creating a debt repayment plan. All of these apply to your financial wellness whether or not you choose to consolidate your debt.
Debt consolidation definition
Debt consolidation is the process of simplifying your debt payments into a single debt payment (or as few payments as possible). It is most commonly used for credit card debt, student loan debt and other types of unsecured debt like medical debt or payday loans.
How does debt consolidation work?
The idea behind it is that you take your different debt obligations and lump them into one large package. To do this, you'd leverage a debt consolidation option with more favorable terms, to pay this consolidated debt off.
So instead of having multiple monthly payments to different creditors after you consolidate your debt, you'd only make one monthly payment. And hopefully, this payment is at a lower interest rate.
That being said while consolidating your debt could be beneficial, proceed with caution as it could also end up costing you more in the long run. It's important that you fully understand the repayment terms when consolidating your debt. You also want to make sure that you understand the long-term impact on your finances.
Let's get into this topic in more detail, starting out with some commonly asked questions.
Does debt consolidation hurt your credit score?
In the short term, your credit score could go down if you chose to consolidate your debt. This is because you'd be opening up a new line of credit and transferring a large balance onto it.
Depending on how long it takes for your creditors to update the credit bureaus, your credit report could temporarily show both your multiple debt accounts and your new consolidated debt account. These balances may show until it's reported that your multiple debt account balances have been paid off by your consolidation account.
Also, the inquiry to open the new line of credit where you consolidate your debt could cause your credit to decline temporarily.
Is Debt consolidation the same as debt settlement?
Debt consolidation is not the same as debt settlement. With debt settlement, you enter into a negotiation agreement with your creditors to pay less than what you owe. This payment would occur in the form of a single lump-sum payment.
Legally, lenders are not mandated to enter into debt settlement negotiations but the may be open to it if they can recoup a certain amount of their money.
Debt settlement can also have implications on your credit score. The lender may choose to close your account, leaving you to contend with the impact on your score. They will also report your account as “settled for less than agreed” which stays on your credit report for seven years.
When should you consider debt consolidation?
Debt consolidation might work for you if you:
- Are ready to become debt-free
- Are committed to no longer spending on credit
- Owe more than $10,000
- Want to reduce your monthly payments and/or interest rates
- Want to simply multiple debt payments into one lump sum
- Have potential actions by collection agencies that you need to resolve
- Have run your calculations and know that consolidating your debt will save you money even with any associated fees
Common ways to consolidate debt
Some different ways in which debt can be consolidated include:
1. Zero to low-interest credit cards
Specifically, a credit card with an initial zero-interest window that can help you save money on interest. This however only works if you are able to pay off your debt before the window or time expired. This can be done through a balance transfer which simply allows you to move a balance you owe on one credit card onto another.
2. Debt consolidation loans
Consolidation loans generally take on two forms - secured and unsecured loans.
A secured loan is one in which the borrower puts up collateral for taking out the loan. The collateral could be a house or a car which the lender can repossess should the borrower fail to make payments.
An unsecured loan, on the other hand, does not need any assets to be put forward by the borrower as collateral. This makes unsecured loans harder to get approval for (especially with poor credit). They also tend to be more expensive by way of interest payments and other more challenging qualifying criteria.
A benefit of both secured and unsecured loans is that interest rates charged on either are lower than those charged on a credit card. In addition, the interest rates are typically fixed throughout the life of the loan. This makes the loan repayment process easier and more predictable. The life of the loan is typically 3 to 5 years.
3. Using a home equity line of credit
If you are a homeowner, a big benefit of owning a home is the ability to build equity gradually as you pay off your mortgage. That being said, having a home as a source of equity opens up the option of getting a Home Equity Line of Credit (HELOC).
A HELOC essentially serves as a revolving line of credit based on the equity in your home and similar to credit cards, lets you draw on the funds as you need. However, a HELOC is a form of secured debt, secured by your home.
Care must be taken when applying for a HELOC and we are not fans of using a HELOC to pay debt. 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, you could be in deep water.
It's also not advisable to consolidate unsecured debt like credit card debt into a HELOC which is secured by your home.
Disadvantages of debt consolidation
Aside from the potential impact to your credit score, consolidating your debt may come with some other disadvantages:
1. The life of your debt may be extended with debt consolidation
Often, despite the lower interest rates and lower monthly payments, the lenders often stretch out the life of the loan sometimes beyond that of the original debt. Thus resulting in a borrower paying significantly more than originally bargained for due to compounded interest.
As a result, it's super important to ensure that you understand the underlying costs, fees and interest rates associated with debt consolidation.
2. Associated fees
Fees paid to consolidate debt onto a new credit card or into a personal loan can be high. If you are exploring a debt consolidation company, this can also cost you a lot of money. It's also important to do your research to avoid scams. Keep in mind that, it is by no means necessary to work with a debt consolidation company to consolidate your debt.
3. Consolidation loans on secured debt require collateral
As mentioned, secured loan consolidations are much easier to access. However, they require putting up collateral like your home or car for potential repossession should you fail to pay. This puts you at risk in the case of a default on the loan. Not a good idea.
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.
Your goal, if you chose to leverage debt consolidation, should be to create a plan to pay off your debt as quickly as possible. Also, it's important to keep in mind that it is possible to leverage debt repayment methods to become debt-free without having to consolidate your debt.