Put simply, consolidation is when you take all of your various debts and fuse them into a single payment. However, this simple concept involves several important details that need to be accounted for before proceeding with debt consolidation. The rest of this article covers the different forms of consolidation and what needs to be considered before taking out a loan.
- Seek out the free services of a nonprofit credit counselor. Several organizations can inform you on how best to manage your finances and settle your debts in a way that prevents future issues.
- Figure out why you are indebted. Knowing why you got into debt can help you untangle yourself from it. For example, if your spending has overtaken your income, a consolidation loan is not likely to achieve much unless you also raise your income or lower your spending.
- Establish a budget. List your expenses each week, month, or year, then look at your debts to see how you can tweak your spending to diminish them.
- Communicate with your creditors to see if they will consent to lowering your payments. There is always a chance that a creditor might lower your minimum monthly payment, ignore some fees, lower your interest rate, or even change your recurring due date to better synch with your paydays, all in order to help you escape debt sooner.
Types of Consolidation Loans
If you are looking into consolidating debt, there are a few options available to you, each of which has several considerations you be mindful of.
Credit Card Balance Transfers
Most credit card companies will offer you a 0% or low-interest balance transfer as an invitation to consolidate your credit card debt to a single card.
What Should I Know?
While those promotional rates for transfers are nice, they do not last forever. Once the disclosed period of time for the promotion concludes, that interest rate is going to rise and that rise is going to hurt how much you will need to pay back. You will also likely have to pay a balance transfer fee, either as a percentage of the amount you transferred or a fixed amount, whichever winds up paying out better for the creditor.
If you use the same credit card to make new purchases, you will not be able to apply a grace period for those purchases and must pay interest on them until the entire balance is settled, including the balance you transferred, to begin with. If your payment is more than 60 days behind, the credit card company can elevate your interest rate on all of your balances, even the transferred balance.
Debt Consolidation Loan
Many varieties of lenders will offer debt consolidation loans. These convert all of your debts into one payment, streamlining your number of payments. Notably, this new loan is often set at a lower interest rate than what you may have been dealing with.
What Should I Know?
A lot of these lowered interest rates from a consolidation loan may be teasers, lasting for a limited period. Once that time ends, you can expect your interest rate to rise. Although your monthly payment might be lower, that may be because your lender is playing a shell game with how long you will need to pay it off. In short, you might owe less by consolidating, but the fees and costs incurred will mean you wind up paying more money than if you had not consolidated.
A piece of advice: If you are considering this sort of loan, compare and contrast the loan’s terms and interest rates to see how much you’ll be paying in total with interest and fees. Even this bit of homework can pay off in less of your money going to other parties.
Home Equity Loan
This sort of loan is set up to allow you to borrow against the equity of your home. When you use it to consolidate your debt, the loan is used to pay off your existing creditors; after that point, you shift to paying back the home equity loan itself.
What Should I Know?
This sort of loan may yield a lower interest rate than other loans but using your home’s equity to manage your credit card debt is risky. Fail to pay the loan back and your home could be foreclosed. You could also be on the hook for closing costs, potentially hundreds to thousands of dollars, with this sort of loan.
Also, be mindful that putting your home’s equity up for a loan risk placing you “underwater” if your home’s value drops. If that happens, you will have an uphill challenge when selling or refinancing the home. If you use your home’s equity as a means of consolidating debt, it may not be available to you for an emergency or to cover expenses like renovations or repairs.
Other Factors to Consider Before Consolidation
Using new debt to manage old debts may just be a stopgap measure. Few people succeed in paying off debts in this manner without also cutting back on how much money they spend.
Loans that you take out to consolidate debt may wind up eating more of your wallet than if you had stayed on your previous debt payment plans, thanks to the various fees and rising interest rates involved with consolidation. If your debt winds up harming your credit score, you will not be likely to find lower interest rates on your balance transfer, consolidation loan, or even your home equity loan.
Watch out for any promotions about debt consolidation that appear to be too effective to be a reality. A lot of companies will promote consolidation services when they are actually debt settlement companies that will charge you up-front fees in exchange for a promise to settle debts. These debt settlement firms will also try to get you to stop the repayment of your debts and shift your financial attention to transferring money into a special account. Lastly, these services are far from reliable and merit an extra level of scrutiny before you ever consider agreeing to deal with them.