Money » Get Out Of Debt » Debt Consolidation Full Guide: How Does It Works?
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Debt Consolidation Full Guide: How Does It Works?

Debt Consolidation can be good in different situations and very popular among high debt borrowers. However, you should be aware to all aspects and understand the consequences of the decision. And of course - make sure you it's done correctly. Here's the things you need to know about debt consolidation in the US
Author: Russell White
Russell White

Writer, Contributor

Experience

As a finance geek and Content editor with 13 years of journalism experience, Russell makes sure every article has the right flow, edits for accuracy, and consumer value. In addition, Russell contributes his own ideas about budgeting, savings, and credit cards.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.
Author: Russell White
Russell White

Writer, Contributor

Experience

As a finance geek and Content editor with 13 years of journalism experience, Russell makes sure every article has the right flow, edits for accuracy, and consumer value. In addition, Russell contributes his own ideas about budgeting, savings, and credit cards.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

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Table Of Content

In this fast-paced world, almost every individual has a loan; Many people, however, have even several of them – one for the house, one for the new car and a few credit cards. For each one of them, of course, the person should pay a monthly installment, making it a real challenge to manage – different dates, different rates, etc.

A majority of Americans have a plan to reduce their personal debts within specific timelines, based on a poll conducted by Northwestern Mutual. 45% of Americans expect to pay off their debt in 1 to 5 years, compared to 9% who expect to pay debts for the rest of their lives. 34% of the respondents expect to pay off their debt in 6 to 20 years. Only 12% of the respondents said that they do not know how long they will be in debt.Chart: Time Consumers Expect to Remain in Debt in the U.S. 2021

What Is Debt Consolidation?

As per Longman Dictionary of Contemporary English, a debt consolidation loan is “a loan used to pay back a number of existing loans, so that payments are only made to one lender instead of to several.”

What are some of the main advantages and reasons for debt consolidation:

  • Lower interest rate which will automatically result in smaller monthly payments
  • Better repayments management
  • A clear image of the period in which you have to repay your debt and the day when you will be free of any liabilities.

You do understand that it's virtually impossible to combine and “unite” your currently existing loans due to several factors – they might be borrowed from different lenders, the term of each loan is different, the interest rate, etc.

How to Start?

So, to “consolidate” your whole debt, you need to get a completely new personal loan, which you use to pay off all your currently existing debt (usually smaller loans – credit cards, overdraft, bills, etc. )

Then, the only thing you have to worry about is repaying the new loan. For sure, this is a much more manageable option, giving a clear image of your debt, financial status, and future planning. Banks and credit unions are the most common issues of debt consolidation loans. Some people, in addition, use debt repayment programs which are also a type of debt consolidation.

Reasons For Debt Consolidation

1. Better Financial Management– instead of having several dates on which you have to pay and monitor each month, by getting a debt consolidation loan you end up with just one “holy” day to think about.
2. Lower Interest Rate – you saw the example and the amount of interest a borrower might pay. It's something to seriously consider. It would be great to pay off existing debt with a higher rate with a new personal loan with a lower rate, wouldn't it?
3. Affordable Monthly Installment – by decreasing the rate on your loan and, if you can, extending the term of the new loan can result in much smaller monthly payments.
4. Shorter Term – this works only if you manage to lower your rate on the debt consolidation loan and retain the monthly installment. This will eventually result in paying off the loan faster.

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How to Consolidate – Example #1

Stephen is just a normal husband and father and a diligent accountant. Even though he works hard, his family have their needs. First, he takes one credit card – $3,500, then another one – $5000 and eventually a third one – $6500. At first, it was easy for him to repay his debt on his first credit card.

After the second one, it got a little bit more challenging financially. The third credit card made it hard for him to manage – different payments, different dates, different rates. It's good to mention that the highest rate was on his third credit card, unfortunately.

What can Stephen do?

Since we have been talking about debt consolidation, this is what he can do – take out a personal loan to cover all his current debt and consolidate it in the form of a single monthly payment with a fixed rate.

If his credit score is good, it's possible for him to negotiate a lower interest on his new loan, which will for sure lead to a lower monthly installment.

How to Consolidate – Example #2

Now, let's give another, more detailed example using some calculations and make it more “visible to the naked eye.”

Now it's Helen's turn. She is an office manager at a local company, and currently, she has three loans. The first one is a six-year $10,000 personal loan at 12.5% rate.

Her monthly payment is $208.7, and the total amount of interest is $5,029. In addition to that, she has two credit cards – the first one is $5,000 for 4 years at 8.5%, which results in $123.2 each month totaling $915.6 in interest for the whole period. Her third loan is a credit card of $7000 for a five-year period at 10.5%. Here, the monthly payment for the card is $150.5 and the interest paid over the whole term is $2,027, almost a quarter of the amount she has to pay.

In this situation, Helen's total principal debt is $22,000, her overall monthly payment is $482.4 and the whole interest on her loans is $7,971.6.

Fortunately, Helen is a diligent payer and has a great credit score, which convinces one of the lenders to give her a debt consolidation loan for $22,000 at 7.5% over a five-year period. Her monthly installment is $440.8. With the same principle of 22,000, she has to pay $4,450 in interest.

So, she reduces both her monthly payments and significantly the interest she has to pay on the new loan.

Advantages Of Debt Consolidation

A debt consolidation loan can literally save the day. There are many people who cannot breathe because of the amount of debt they have accumulated and cannot curb anymore. Also, their interest rates are pretty high and they cannot renegotiate better terms.

Have you been harassed by collection agencies recently?

If the answer is yes, then it's perhaps you owe more than $10,000 to multiple lenders and you have overdue payments. If you get a debt consolidation loan and pay off your existing debts, then the unpleasant calls will cease.

Most probably you are taking a debt consolidation loan to make up for overdue payments on several loans, which means that your credit rating has been negatively affected.

Do you want to improve your credit score?

If you pay off the principal using the new loan, this might improve your credit score. If you still don't know your credit score – learn how to find it out.

Taxes, taxes, taxes. Need a break? You may qualify for a tax deduction if you manage to secure your new loan with an asset, especially if this asset is your home.

Your credit score can influence not only your credit card rate, but also your available credit limit. This chart using Experian data shows the average credit card debt by credit score. It shows that those with an average to good credit score have the highest amount of credit card debt.

This highlights that those with excellent credit scores are more likely to have a lower credit utilization ratio, and therefore carry less credit card debt. It also suggests that those with poor credit scores are more likely to have lower credit card limits or use alternative forms of credit.

Average Credit Card Debt by Credit Score

Disadvantages Of Debt Consolidation

Nothing, ladies and gentlemen, nothing is perfect. Despite the fact that it looks like a great opportunity, there are some things you need to be careful with before taking your debt consolidation loan.

Sometimes these loans have higher rates and, if you haven't done your maths, you might end up paying more each month and repaying the debt even longer. By doing this, the amount of your debt will increase. Double trouble. Therefore, consult professionals who might give you sound advice in order to avoid some serious pains in the future.

Another thing to keep in mind is to avoid borrowing more money than you actually need, Yes, we all want a new car or a bigger house, however, can you afford it? Debt consolidation loan is an instrument to alleviate your financial issues not make them worse. 

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Types of Debt Consolidation

There are different ways of consolidating the debt:

Credit Card Balance Transfers

If an individual wants to unite his credit cards,  it would be wise to consolidate them in just one, notably the card with the lowest rate or a new one which is interest-free for a period of time. Keep in mind that increasing the debt on a single card might lower your credit rating.

Home Equity Loans

Home Equity Loans are loans in which your home is used as collateral. Even though they indeed offer the lowest rates, it's quite risky and should you fall behind your payments, your home is at risk of foreclosure.

Personal Loans

Remember Helen? She used one such loan to consolidate her two credit cards and personal loan. This is an unsecured type (you do not have to secure it with assets) and usually, offers fixed payments over the whole term. To successfully qualify for a low-interest loan, you need to have a good credit rating.

Average Loan Amount by Loan Type

Federal Loan Consolidation

Federal Loan Consolidation is offered by the government to people who have problems repaying their student loans (see student loan consolidation)

Don't Put Your Home at Risk

Sometimes, the situation might get out of control, but it doesn't mean you have to put your home at risk. When taking a debt consolidation loan try to opt for the best product in the market – low interest rate.

Consolidate using an unsecured personal loan – the lender has no claims on your property or other assets because you have not secured the loan should you fail to repay it on time. Logically, these loans require the best credit score.
Don't take a debt consolidation loan if:

  • The new payment on your loan is too high
  • You use the consolidation loan to spend rather than pay off your existing debt
  • The rate is higher than the interest on your old loans and the payment is actually higher
  • Perhaps your monthly installments are lower, but the term is much longer; this means the total value of the debt will increase.

Fees and Charges

There's no free lunch, is there? You should be extremely careful when signing the contract for your new loan since plenty of lenders charge quite heavily for arranging the loan.

First, read carefully your contract; sign only when you have checked the “small print.” Second, try to locate if there are any clauses in the document, which would make you pay fees in case you paid off the loan before its term.

Be ready to pay for a company to represent you and speak on your behalf? Yes, but only if they do so.

Bottom Line

Loans are loans and debt is debt. You take a new one to pay off old liabilities. Undoubtedly, paying less each month and over the whole period might be crucial.

Nevertheless, do not forget that this was your choice – did you really need that expensive bike or a new phone? So, being financially responsible requires discipline and serious commitment.

Next time you want to run up new debt, ask yourself: Do I really need this?

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