When the challenge of managing debt payments becomes overwhelming, debt consolidation may provide relief. While not appropriate for all consumers, debt consolidation can help make your debt manageable by reducing the number of payments you have to make, lowering the amount of interest accruing on the debt you owe, and helping you pay off your total debt quicker. However, while debt consolidation can be a helpful avenue to managing debt, it is not without risk.
How do you know if debt consolidation is the right option for you? Here are the top debt consolidation Q&As to help you decide.
What is debt consolidation?
Debt consolidation simplifies debt repayment by transforming multiple debts into one. Consumers with several credit cards, active loans, or other outstanding debts may struggle to keep track of all the due dates and make payments timely. With debt consolidation, a large sum of money is borrowed to pay off multiple other debts. Then, instead of having to make multiple debt payments each month, the only outstanding balance is for repaying the money that was borrowed to pay off the other debts.
Typically, debt consolidation means one monthly payment and one interest rate, which can result in significant savings to the consumer over time. By the time the balance is paid off, the consumer often will have paid less overall interest, over a shorter amount of time, through fewer payments than had multiple balances been paid on over an extended period. The potential savings through debt consolidation depends on the consumer’s credit score and history.
How does debt consolidation work?
Generally, debt consolidation can be accomplished with a credit card or a loan. Using a home equity loan or borrowing from your 401(k) are other options for consolidating your debt, but the risk with these options is great as it can impact your home, retirement, and general financial future.
Consolidating Debt with a zero-percent interest, balance-transfer credit card
Credit card providers frequently offer zero-percent interest promotions to bring in new cardholders. If you have good credit but are just struggling to keep track of the multiple payments, varying due dates, or cannot seem to get ahead due to high-interest rates, you may consider consolidating your debt with one of these credit cards. You can use this card to consolidate your debt by transferring other high-interest credit card balances to this zero or low-interest account and using this card to pay off other outstanding financial obligations.
Though it may seem risky to use one credit card to pay off another, this strategy of debt consolidation can be effective and virtually risk-free so long as you can pay off the full balance within the low or zero-interest promotional period. Using this method will allow you to pay off your outstanding debt without having to deal with constant balance increases from the accruing interest.
However, anytime you open or close a line of credit, such as paying off an existing debt or getting a new credit card, your credit score will be affected, especially if the new high balance credit card ends up being a new debt you cannot afford to pay. Therefore, it is important to be strategic in managing these accounts and only pursue this method of debt consolidation if you are confident you can pay off the full balance before interest begins accruing or skyrockets to the normal rate which is often quite high once the promotional period ends.
Using a fixed-rate loan to consolidate debt
This is probably the most common option, as there are many debt settlement companies that use this option to help consumers get out of debt. A debt consolidation loan is usually an unsecured personal loan. Like the credit card option above, the debt consolidation loan is used strictly to pay off existing debts. Typically, these loans have a fixed interest rate and a repayment period.
Rather than making payments on multiple accounts, the funds borrowed through the consolidation loan are used to pay the balance on outstanding debts leaving the consumer responsible for making only one debt payment to the provider of the consolidation loan.
Home equity loans and lines of credit to pay off debt
Consumers can usually borrow most of the value of the home’s equity through a loan. The money borrowed through a home equity loan must be repaid according to specific terms. Like a credit card, a home equity line of credit (HELOC) allows consumers to have access to money on-demand, paying interest only on the money that is actually borrowed. However, the fees and risk associated with home equity loans and lines of credit can be great.
What are the benefits of debt consolidation?
Debt consolidation can make it easier to manage your financial obligations by combining multiple debts into one. When you are juggling multiple accounts with high-interest rates, such as credit card debt, debt consolidation can also help lower the total amount you pay over time by decreasing the interest accruing on your collective debt. Because of this, you may also be able to pay off your debt more quickly when it is consolidated as opposed to paying off each account separately. Debt consolidation loans may all provide certain tax advantages.
What are the risks of debt consolidation?
Debt consolidation is not appropriate for everyone. The risks of debt consolidation depend on the source of funds used to consolidate your debt. If you elect to use a second mortgage or home equity line of credit to consolidate your debt, your home is collateral. This means that if you experience further financial strain are unable to make payments timely or at all, the risk is losing your home.
While interest may not necessarily be a risk, considering that the interest associated with debt consolidation is typically less than what you would otherwise collectively pay in interest on multiple outstanding accounts, there may also be pay “points” accumulating which are an additional expense typically equal to one percent of the amount borrowed. Further, some repayment terms could be longer, so the consumer will end up paying more on the debt despite the lower interest rate.
