How Does Debt Consolidation Work?
While many borrowers may have heard of debt consolidation as a strategy for paying down debt faster, few people have an idea of how to answer the question “How does debt consolidation work?”
With that in mind, we’ve created a primer on the subject below. Keep reading to learn more about how consolidating your debt works, how to tell if this financial strategy is right for you, and the different ways you can go about combining multiple debts into one monthly payment.
How does consolidating your debt work?
Put simply, debt consolidation is a method of combining multiple debts into one loan with one monthly payment. Borrowers typically try to find a debt consolidation method with a lower interest rate than the one they are currently paying, which helps them save money overall.
When it’s done correctly, consolidating your debt can help you pay it off faster. However, debt consolidation is only one method for simplifying your finances. It does not get rid of your debt entirely and it may not be the best choice for everyone. So before you take steps to get a new loan, it’s important to understand whether or not this personal finance option is right for you.
Does debt consolidation make sense for you?
Now that you know more about the importance of clarifying whether or not debt consolidation makes sense for you, the next step is to learn how to make this decision. In light of that, we’ve listed some signs below to help you weigh your options. Read them over to learn more.
Signs debt consolidation might be the right choice
- You’re having trouble staying on top of your current payment schedule: Debt consolidation can help you combine multiple payments and due dates into one. Ultimately, this can make remembering to make your payments much more manageable.
- You have enough cash flow to pay down your debts: However, since debt consolidation does involve combining multiple payments into one, your monthly payment will likely be much larger when you consolidate. You’re going to need to make sure you have enough cash flow to make a payment of that size.
- You have a decent credit history: Whether you open up a balance transfer card or a debt consolidation loan, your lender is going to look at your credit history to approve you for a new account. With that in mind, debt consolidation only makes sense if you have a high enough credit score to be approved for a new account at a decent interest rate.
- You’re able to change your spending habits: Consolidating debt only makes sense if you’re able to change your spending habits to avoid running up new debts.
Signs it might make sense to explore other options
- Your debt load is too small: Generally speaking, if your debts are small enough that you can pay them off within six months or a year, it likely won’t make sense to consolidate. You should try a payoff method like the debt snowball or debt avalanche instead.
- Your debt load is too large: As a rule of thumb, if the total of your debts is more than half your income, it will likely make more sense to look into debt settlement options instead.
- You have a poor credit history: A poor credit history often goes hand-in-hand with being charged higher interest rates. For example, if you’re given a debt consolidation loan with a high interest rate, it could end up costing you more money in the long run.
Common methods for debt consolidation
If you’ve looked at the information above and decided that debt consolidation is likely the best method for you, it’s crucial to know a few different routes you can take to make it happen. We’ve listed them below for your consideration.
Balance transfer credit card
First up, is a balance transfer credit card. As the name suggests, this type of card allows you to transfer existing credit card balances onto it, combining them into one. While transferring a balance from one card to another can come with a small fee attached, they often have a 0% APR introductory rate offer. You’ll likely have the chance to pay down your debts without worrying about extra interest charges for a while. But, unfortunately, these cards are usually only an option for those with good or excellent credit.
Home equity loan
If you own your own home, you may be able to consolidate your debt using a home equity loan. A home equity loan functions similarly to a second mortgage. Here, you would borrow against the equity you’ve built up in your home and the money would be given to you in a lump sum. That said, since your home will be used as collateral for the loan, the lender may choose to foreclose on your property if you cannot make your payments.
Debt consolidation loan
Lastly, many people tend to wonder, “How do debt consolidation loans work?” Fortunately, the answer is relatively simple.
A debt consolidation loan is just another name for a personal loan that is used to consolidate debt. Since personal loans are usually unsecured, these loans also typically require a decent credit score to be approved.
Still, if you don’t own your own home, these loans can be a good opinion for consolidating debt at a lower interest rate than you might receive with a balance transfer card. For reference, the Federal Reserve estimates that the average interest rate on a personal loan is 9.5% while the average interest rate on a credit card is 14.6%.
The bottom line
While debt consolidation can be a decent strategy for helping you pay down your debt faster. It may not be the right choice for everyone. Use this post to help you determine whether or not debt consolidation is the right move for you. Armed with this knowledge, you should have a much better idea of how debt consolidation works and how you can get started on the process.