What Is Debt Consolidation? – Ways to Consolidate Debt

Being in debt is stressful and frustrating. When you accumulate more debts than you can afford, it’s easy to get trapped in a tough financial predicament and lose control of your finances.

Debt consolidation is a possible solution for consumers who want a convenient, streamlined way to manage their debts. However, as with any other loan, there are pros and cons involved in consolidating your debts.

You’re probably wondering, “Is debt consolidation a good thing?” To help you understand this repayment strategy, we’ll discuss what exactly debt consolidation means, the different ways to consolidate debts and the advantages and disadvantages of these loan consolidation options.

what is a debt consolidation loan

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What Is Debt Consolidation?  

In a nutshell, debt consolidation involves combining all of your outstanding debts into a single loan, thus eliminating the hassle of repaying multiple debts and dealing with various creditors. Having only one new loan payment each month, you get the convenience of paying off your debt to only one lender without worrying about varying debt amounts and interest rates.

The new loan features different terms compared to your existing financial obligations. Many people use debt consolidation to manage credit card debts, student loans, personal loans, and other debts that are not backed by collateral.

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Advantages of Debt Consolidation

The next step to knowing “What is loan consolidation?” is learning about its benefits and drawbacks. The major benefits of consolidating your loans include the following:

  • Low-interest rates

Credit card debts usually come with skyrocketing interest rates that reach up to 25% or higher. Being stuck with hefty interest rates will inevitably expand your debts until you’re neck-deep in bills. In this case, a consolidation loan may offer you a lower interest rate, helping you save in the long run.

  • Simplified repayment process

Many people find it hard to get out of debt because they can’t keep track of so many bills, leading to missed and late payments. Consolidation saves you the trouble of monitoring numerous bills and allows you to focus on a single monthly payment.

  • No negative effects on your credit score 

Unlike debt settlement, which affects your credit score, debt consolidation allows you to fully pay your credit commitments without negative repercussions to your credit score.

Is Debt Consolidation Good?

A debt consolidation loan can help make repayment much easier; however, this option is not for everybody. While this payoff tool allows you to pay off your entire credit card debts through a single monthly payment to your chosen financial institution, keep in mind that it’s still a financial product, and most financial institutions wouldn’t offer consolidation loans without the prospect of making a profit. Some consolidation loans do help debtors get back on track, but there are lenders that prey on unsuspecting debtors and make their financial matters worse.

You may ask then, “Is debt consolidation bad for managing my debts?” Not exactly. Whether a debt consolidation loan is a wise strategy or not largely depends on your particular financial situation. Also, if you choose to seek help from a debt consolidation company, you need to select a trustworthy firm that doesn’t charge exorbitant fees.

When asking yourself “What is a debt consolidation loan?” you probably also want to know the possible downsides to this payoff strategy. Ask yourself these questions to determine if a debt consolidation loan may actually become beneficial for you:

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Do you have excessive debt?

If you’re buried in piles of financial obligations and you’re no longer capable of negotiating lower interest rates with your creditors, a debt consolidation loan is possibly a smart move. The loan can help you repay your debts at a significantly lower cost, especially if your outstanding debts involve high-interest rates and expensive monthly payments. Seek credit counseling so you can devise a good repayment plan that will help you get out of debt.

Does your potential debt consolidation loan help you save more?

Calculate your overall credit card debts and find out the time you need to repay all of them at your existing payment rates. Compare it to the length of your prospective consolidation loan. If your debt consolidation loan costs less in the long run, then it makes sense to take out the loan. However, if you can save more by paying down your credit cards more quickly, a debt consolidation loan is not for you.

How do your monthly payments compare to your debt consolidation loan?

Determine the monthly payment on your debt consolidation loan, and see if it’s less than your monthly payments for your credit card bills. If your new consolidation loan has a lengthy-term, you may have to pay more interest over the long haul even if your interest rate and monthly payment are lower than your previous payments.

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Ways to Consolidate Debt

Debt consolidation generally falls under two categories: secured and unsecured loans. A secured loan means you back your loan with valuable property, usually a home or car. If you default on your payment, your creditor can foreclose your home to obtain payment for your loan. On the other hand, an unsecured loan doesn’t require any form of collateral or security for repayment, which is why it often has a higher interest rate.

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Image Source: Consolidating Your Debts

Consolidating Your Debts Through a Secured Loan

There are various ways to consolidate debt using secured loans. These include refinancing your home, taking out a car loan, applying for a second mortgage, or getting a home equity line of credit. You may also take out a 401k loan, in which your retirement funds serve as collateral.

Advantages of a Secured Consolidation Loan

The main benefit of taking out a secured loan is the opportunity to get low-interest rates, allowing you to save on interest payments. You’ll likely have a more affordable monthly payment compared to an unsecured loan. In some cases, interest paid on a secured loan counts as a tax deduction. Additionally, a secured loan is easy to acquire if you qualify. Some consumers consider a secured loan the best way to consolidate credit card debt due to low-interest rates. 

Disadvantages of a Secured Consolidation Loan

With a secured loan, there’s always the risk of losing your collateral. Make sure to pay on time and avoid missing payments; otherwise, you could lose your home, vehicle, or other possession that you used to secure your loan. Your expensive property is on the line, so you need to determine if you’re capable of faithfully paying off the loan and if you’re ready to take the risk.

Also, as mentioned earlier, a consolidation loan may have a longer-term compared to your current debt obligations, which means you’ll end up paying more interest than you would have paid on the individual debts.

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Consolidating Your Debts Through an Unsecured Loan

 Because an unsecured loan involves more risk for the lender, the loan is usually harder to obtain for borrowers who need it the most. Unsecured debt consolidation loans for people with bad credit are hard to come by, as an excellent credit score is crucial to qualify for an unsecured loan with a relatively low-interest rate.

Zero-percent interest credit card balance transfers are an alternative for an unsecured consolidation loan. However, be aware that missing a payment or making a late payment means you’ll have to pay interest right away. More importantly, if you find it hard to cut down on your spending, using another credit card that tempts you to splurge may not be an ideal solution to your financial problems.

Advantages of an Unsecured Consolidation Loan

A common question among borrowers is “What is the best way to consolidate debt?” Many debtors choose unsecured loans because there’s no property at stake. If you fail to pay your loan, your lender cannot take any of your property as there’s no collateral involved. If you get an interest rate that’s lower than what your creditors charge, you’ll be able to save on interest and have a lower monthly payment.

Disadvantages of an Unsecured Consolidation Loan

A considerable drawback when taking out an unsecured loan is the difficulty of obtaining the loan if you don’t have a good credit score. Moreover, interest rates are usually higher. Also, when you use a no-interest credit card, there may be a transfer fee that nullifies your potential savings. Because the introductory period is limited, you’ll likely have to pay higher interest after the special offer ends if you fail to pay off your debt during the no-interest period.

Managing Your Debts Through a Debt Consolidation Company

Numerous debt consolidation companies offer the promise of helping you get out of debt. Basically, you’ll take out a new loan from a consolidation firm, and the company will take care of your credit obligations for you. You’ll have to pay a single monthly payment to them, and you won’t owe money to your previous lenders anymore.

However, if you’re like most people with debt problems, you may have a poor credit score, which doesn’t help in getting favorable interest rates. The high interest and costly fees involved in a debt consolidation loan can significantly affect your overall monthly cash flow.

And as we’ve repeatedly mentioned, even if you get a lower interest rate than your previous debt obligations, you might end up paying more interest over time if your repayment plan is longer. Depending on your consolidation company’s policies, missed and late payments may come with certain penalties, such as raising your interest rate.

To make your repayment plan successful, follow these tips:

  • Choose a short loan term. Instead of taking the maximum period to repay your new loan, try to settle your debt within three to five years or less.
  • Review the fine print carefully. Make sure there are no unexpected costs and fees, especially when it comes to application fees and balance transfers.
  • Shop around. Different financial institutions offer varying interest rates and fees, so compare several firms and consider your options carefully before choosing a debt consolidation service.
  • Be wary of predatory lenders. If the offer is too good to be true, it probably is. Be sure not to fall for traps, and move on to another financial institution if your prospective lender offers unbelievably good loan terms.

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Changing Your Spending Habits

While debt consolidation offers an easy and convenient way to repay multiple debts, it’s important to understand that improving your financial status largely depends on your spending behavior and motivation to manage your finances wisely. If you continue to rack up more debts while paying off your financial obligations, you’ll likely end up in a sticky situation and start the cycle all over again.

To avoid amassing expensive debts, control your spending by setting a realistic budget each month and allocating a portion of your income to an emergency fund. Avoid luxurious purchases, and bring cash with you when shopping. This way, you’ll be able to avoid falling back into your old credit card splurging habits.

Sit down, take a good look at your current financial situation, and evaluate whether you can actually manage your debts on your own or whether you would benefit from paying a financial institution to settle your debts for you. Knowing what debt consolidation is and when it makes sense, you can make an informed decision that will help ease the burden of being in debt.

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Is Debt Consolidation the Right Choice?

Whether debt consolidation is a smart solution or not depends on your financial situation, level of motivation, and capability to stop overspending for good. If the interest rate and overall payment amount work out in your favor and you’re confident that you can commit to your new monthly payment, a consolidation loan can be a useful financial tool. Keeping yourself well-informed of different ways to consolidate debt will go a long way in getting rid of your debts successfully.

To recap, a consolidation loan makes sense if:

  • You have too many debts with high-interest rates and high monthly payments.
  • Your new consolidation loan offers a low-interest rate and a more affordable monthly payment.
  • The loan helps you save more in the long run.
  • You have the ability to avoid unnecessary purchases and avoid accumulating new debts while paying off your consolidation loan.

If you want to consolidate your loans simply for the sake of convenience, debt consolidation may not be a good idea.

Now that you can answer “What is debt consolidation?” it’s best to take charge of your finances and practice being a wise, thrifty consumer. By using an efficient repayment strategy and sticking to your financial goals, you can regain sound financial health, and you’ll be on your way to living a debt-free life.

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