Managing debt can be stressful, to say the least. While many of us have to take on debt from student loans or a credit card, the path to paying it off doesn't always feel so clear.
Debt consolidation is the process of combining all your debt into one payment. Kinda like keeping all your car and house keys in one place, so they’re easier to find when you're rushing out the door.
Nobody likes to be making tons of payments to different companies each month. Although figuring out whether debt consolidation is right for you depends on your individual circumstances.
Let’s jump into exactly how debt consolidation works and when it might be time for you to consider it.
What is the Process of Debt Consolidation?
To consolidate debt, borrowers must roll their pre-existing loans and debt into a new loan that covers them all. Consolidating debt can help reduce your monthly payment by providing you with a lower interest rate and extending the length of your loans.
For example, you might roll up two 3-year loans and a 1-year loan into a 5-year loan. This would reduce your monthly obligation.
Debt Consolidation can also be used to just simplify the number of payments you have or get rid of debt faster if you would like to accelerate the timeline in which you pay off your debts.
This can be important if you want to make a big purchase (i.e. a house or car) in the coming years and want to tackle all your debt head-on.
Debt Consolidation Options
Different types of loans can be used to consolidate debt, each with varying impacts. In general, these loans can be either secured or unsecured.
Secured loans are loans that have to be backed by an asset, such as your house or another valuable asset of yours. This protects the lender in case you default, as the lender can then seize this asset.
Unsecured loans are not backed by an asset. This increases the lender’s risks and, as a result, typically means your interest rate on the loan will be higher. You may also be unable to qualify for as large of an unsecured loan as you may for a secured loan.
Below are some specific loan options you can use to consolidate debt:
Personal Loan
Personal loans are lump sum amounts that are typically offered as unsecured by banks and credit unions. Once you take out a personal loan, you then have a set repayment time in which you must repay the loan. There are even personal loans specifically for debt consolidation called debt consolidation loans.
Credit Card
Switching to a new card can be a way of consolidating debt if the new card offers a lower interest rate than your other card(s). This is often an option for individuals who have multiple outstanding credit cards with high-interest rates and want to consolidate their debt onto just one card.
However, if you decide to go this route, you will have to stop spending on your old cards. Otherwise, you will only continue to magnify the amount of debt you have, making the debt consolidation strategy counterproductive for you.
Line of Credit
Personal lines of credit are another way to consolidate debt. However, lines of credit typically have variable interest rates, so there are risks associated with putting a lot of debt on a line of credit. Changes in interest rates could result in much higher payments than you originally expected, making the debt even more expensive than it was pre-consolidation.
HELOCs
HELOCs are home equity loans that are based on the value of your home. Some HELOC options come with a variable interest rate, subjecting you to a similar risk as that of a line of credit. However, some come with fixed interest rates as well. You can imagine a HELOC as essentially taking on a second mortgage payment.
Pros and Cons of Debt Consolidation
Debt consolidation comes with pros and cons based on the individual circumstances of the borrower and the loan options available to them.
Let’s run through the advantages:
Lower Payments
When executed properly, debt consolidation will reduce the value of the payments you have to make. Whether through a lower interest rate, a longer repayment timeline, or something else, debt consolidation should only be considered if you are going to end up saving money or paying the same amount as you would pre-consolidation.
Fewer Payments
Through consolidating debt, you can reduce the number of payments that you have to make to lenders. This can make things easier to keep track of and allow you to better manage your finances.
How about the bad that can come with debt consolidation?
Risk of Increasing Debt
Now that you have consolidated your debt, you will have to change your spending habits. For example, it is not uncommon for individuals to consolidate debt onto one credit card and then begin spending with their old credit cards. This is a recipe for disaster and can exacerbate an already bad debt issue.
Unable to Qualify
Unfortunately, there is no guarantee that you will be able to qualify for a debt consolidation loan. If your credit score is very low and you already have a large number of outstanding debts, new lenders may not be willing to take a risk by providing you with a debt consolidation loan.
Paying Higher Interest Fees
If you do not structure your debt consolidation properly, it is possible that you could end up paying higher interest fees than you were paying pre-consolidation. This is why you need to be extra diligent in ensuring you understand the terms and conditions of any debt consolidation loan you take out.
Is Debt Consolidation a Good Idea?
Debt consolidation can make sense for a wide array of individuals who currently have a number of outstanding loans and payments that they have to make.
However, the circumstances have to be right. For instance, if interest rates are significantly higher than when you took out the debt initially, it may not make sense to consider debt consolidation.
So, before you make a decision, make sure to do your homework. When done right, debt consolidation can make a world of difference for borrowers. If done improperly, debt consolidation can serve to only make a tough financial situation even more difficult.
That being said, make sure you pay attention to all the details and nitty gritty consequences of debt consolidation before making any big moves.
Read up on Extra’s blog for more financial tips and credit knowledge.
