Rolling all your debt commitments into one- is it as convenient as it sounds? Know the ins and outs before making the call.
Table of content-
- What is debt consolidation and how does it work?
- Types of debt consolidation
- Should you take a debt consolidation loan?
- Is it better to take a debt consolidation loan or personal loan?
- How does debt consolidation loan affect your credit score?
- Can I get a loan after debt consolidation?
With ever-deepening levels of debt and the resultant concerns, more so as a product of the COVID-19 pandemic, it is not unusual to find yourself reassessing your personal financial situation. As per a research study from Northwestern Mutual, 60% of US adults are anxious about their level of debt.
Total debt this year grew from $4.24 trillion in May to $4.27 trillion in June, according to dollar figures. Inflation is on the rise and consumer prices reached 5.4% more in June. The current state of affairs is such that about 31 percent of Americans report feeling depressed at least once a month on account of financial anxiety. At the same time, however bleak the prospects might seem for debtors, there are steps you can take to ease the burden.
If you are finding it challenging to juggle multiple credit commitments and staying on top of monthly repayments stemming from various loans, a debt consolidation loan might be the solution for you. In this guide, we dig deep into how it works, the different types of debt consolidation loans, and whether you should consider these for your case.
What Is Debt Consolidation?
In case you have several ongoing debt commitments leading to multiple monthly payouts to different sources, opting for debt consolidation would mean rolling it all into one to streamline your payoff strategy.
Merging your debts into a single loan can work to lower the interest rate and cut down on your monthly payments, besides allowing the convenience of servicing only one debt.
In a nutshell, debt consolidation can be understood as an umbrella term for integrating several debts into one, be it through a balance transfer credit card, a loan, or an agency. The primary purpose is to make the single resultant loan simpler to manage by enabling a single monthly payment at one interest rate to one lender.
How Does It Work?
When availing a debt consolidation loan, the debtor uses the borrowed funds to pay off their outstanding balances with all other lenders. In the case of balance transfer credit cards, there is a process followed to consolidate the individual’s existing cards.
Once the debtor’s outstanding balances have been cleared with the consolidation funds, the borrower will have to make a single repayment on the new debt every month. While this route reduces the amount payable each month, it balances this by stretching out the repayment period of the consolidated debt.
To prepare your debt consolidation plan, you can enlist the services of a credit counseling agency, a financial institution, or a debt relief organization, or even choose to do it yourself. Irrespective of how you go about it, the bottom line is to have a lower interest rate and monthly payment than your previous dues added up.
Debt consolidation loans often have interest rates that vary from 6% to 36%. You’ll need a great credit score to receive a rate at the bottom end of that range (720 to 850 FICO). However, even a good credit score (690 to 719 FICO) may be enough to obtain you a higher return than your current one.
In the next section, we size up the relative benefits and pitfalls of the various ways you can consolidate your debt.
Types Of Debt Consolidation
There are many different routes and channels you can pursue to consolidate your debt. These fall into the two main categories of secured and unsecured loans.
In the case of secured loans, you need to put up an asset, such as your car or house, as collateral. Unsecured loans are not backed by an attached asset as collateral. Defaulting on a secured loan repayment means the lender may come for your house. This makes unsecured loans the safer and more desirable alternative of the two.
The type of debt consolidation you can go for depends not only on your credit score and eligibility for borrowing but also on the kind of debts you owe. Read on to find the types of debt consolidation available out there and evaluate which one suits you best.
1. Debt Consolidation Loan – The most direct way to consolidate your debt is by going for a debt consolidation loan. As mentioned above, it is a single loan taken to pay off all your unsecured debts and replace them with one debt managed with one monthly payment to one creditor. This is an accessible option you can avail of at any credit union or financial institution, provided you have a satisfactory credit score.
2. Personal Loan – Because of their low, fixed interest rate and predictable repayment schedule, personal loans are a popular debt consolidation alternative. An unsecured personal loan does not require the borrower to put up any collateral, allowing them to get money quickly. But, the key difference is that a personal loan is not directly linked to one purpose. Data shows that borrowers who consolidated credit card debt saved an average of $2,000.
3. Debt Management Program – Distinct from the two listed above, a Debt Management Program is centered around credit counseling offered by non-profit agencies and organizations, over three to five years. This doesn’t entail a loan application and is, therefore, better suited for those with below-average credit scores.
4. Credit Card Balance Transfer – This is the best fit if you are planning to consolidate your credit card debt. A balance transfer credit card allows you to merge balances from multiple credit cards into one card with a reduced APR.
5. Direct Consolidation Loan – This is available only in the case of consolidating federal student loans. Application for the Direct Consolidation Loan needs to be made with the U.S. Department of Education.
6. Home Equity Loan – A prominent type of secured debt, home equity loans are backed by your house as collateral. While the added layer of security allows for lower interest rates, your house is on the line and can be at risk in case of default in repayments.
7. 401(k) Loan – This type of loan is backed by your retirement savings. While it may appear an attractive prospect as it doesn’t require a credit check, delays or default in repayment can lead to tax penalties.
8. Debt Settlement – If other alternatives have dried up for you, only then is it advisable to opt for debt settlement. With this method, you may hire a debt relief company to arrange a negotiation with your lenders and reach a settlement where you repay less than the amount you owe. It is recommended as a last resort as it can seriously damage your credit score in the long run.
9. Bankruptcy – While not ordinarily seen as a means of debt consolidation, bankruptcy, in some ways, specifically those relating to restructuring bankruptcy under Chapter 13, can serve the purpose.
Should You Take A Debt Consolidation Loan?
Before making up your mind, do take a moment to pause and consider if debt consolidation is the best remedy for your financial situation. While it may be the perfect answer for one debt case, it may be quite the opposite for another.
If you are paying off multiple loans at high-interest rates, it might be a good idea for you to consolidate the debt and achieve a lower interest rate on the consolidated loan. This will help you cut costs in the long term and make it easier to manage monthly payments. It is also a sensible alternative for borrowers with significant budgets and steady payoff plans.
By contrast, if you are not getting a reduced interest rate on the consolidated debt than you were paying earlier, then it is not advisable to change the status quo. If the new interest rate isn’t reasonably lower, the limited potential savings from it would be compensated by the fees you would be paying for consolidation.
Finally, at the end of the day, even with a consolidated loan, you’ll need to be systematic with your budget and make timely payments, which makes it necessary to have a plan in place.
Is It Better To Take A Debt Consolidation Loan Or Personal Loan?
A debt consolidation loan typically offers a lower interest rate than that of your current debts. Nevertheless, it is still likely to be higher than other alternatives, for instance, a personal loan.
Personal loans are ideally meant for cases where you need some added cash flow for certain products, occasions, or bills. This could be for a significant purchase, vehicle repair, wedding finances, etc. Personal loans are not backed by collateral and are thus, unsecured.
Considering this, it might seem like a good idea to take out a personal loan to consolidate your debts. It is not, however, the recommended route to choose as debt consolidation loans are structured particularly for the purpose of paying off multiple debts as opposed to personal loans that help with cash flow for various other needs.
How Does Debt Consolidation Loan Affect Your Credit Score?
A debt consolidation loan works best when taken as a part of your financial planning, rather than as a way to simply transfer the debt. Serviced with timely repayments, a consolidated loan can be a means to improve your credit score.
Paying off all your credit card debts with the new loan lowers your credit utilization ratio, which bodes well for your credit score. Staying on top of monthly payments for the new debt can keep you on the upward credit track.
At the same time, you can also damage your credit score with a debt consolidation loan. With the opening of a new credit account, the average age of your accounts takes a dip. In other words, this affects the length of your credit history which is a prime factor accounted for in your FICO score.
Can I Get A Loan After Debt Consolidation?
You can refinance your debt consolidation loan after taking it and even go for a personal loan afterward. The lending institution is, however, bound to conduct thorough checks and analyses before dispensing additional loans.
Provided your credit score and history are above average, getting a loan after debt consolidation is possible. In such cases, it is vital to have a thought-out payoff plan in place to avoid being burdened with credit commitments.
To sum up, while debt consolidation can work wonders in streamlining your loans and easing your monthly payoff calendar, there is no one-size-fits-all feature to it. It is only after carefully assessing your financial situation that you can find out if this is the way for you.
Regardless of the choice you make, designing and following through with a personalized, effective financial plan is the key to not letting your credit commitments get the best of you.