Sometimes all the money-saving tips in the world won’t make a difference if your financial life is in chaos. But, when it feels like all hope is lost, debt consolidation may be a lifeline.
Debt consolidation can help you save money on interest, get your credit back on track, and keep you from filing bankruptcy.
What is Debt Consolidation?
Also referred to as loan consolidation, it is the process of using the proceeds from a new loan pay off all your smaller ones. So, for example, you might include your car payments if the loan is relatively small but typically you wouldn’t include your mortgage. A consolidation loan is generally set up through a third-party credit counseling agency or the do-it-yourself system through a peer loan.
It seems weird that taking out another loan would help you get your finances back on track, but it does work. Many people found success through the debt consolidation process.
While it doesn't include the much-needed counseling service, peer lending may be the easier path to debt consolidation. While most peer lenders usually require a FICO score of 640+, there are peer lending options for those with bad credit.
Some financial gurus shun the debt consolidation process because they say it is a salve over a wound but not a cure. In addition, consolidating your debt may put extra money in your pocket at the end of the month since you're making one payment instead of many. However, becoming proficient at managing your money will allow you to use debt consolidation to get back on your feet and not as a way to spend more.
Importance of Debt Consolidation
Many people carry high-interest personal credit card balances. For some, these can reach up to thousands of dollars, more than many have in their savings accounts. If the interest rate on your debt is higher than what you can earn from investments or loans, paying off the debt will be nearly impossible.
In this case, you need a consolidation program that will combine all your debts into one monthly payment. If you don't have a low-interest loan at your disposal, finance charges might swallow up most of your balance before paying off any of it.
Debt consolidation, unlike debt settlement, is a good option if you have a steady income and can make the monthly payments without too much trouble. This strategy aims to reduce the total interest paid over time by paying down multiple high-interest debts with just one loan. Therefore, it's essential to find an interest rate lower than what your other creditors are charging.
Many people who consolidate loans take out credit lines at their local bank or credit unions. But before signing up for a new loan, talk to your current lenders and ask them if they would consider lowering your rates so you could refinance the entire balance into one account.
When consolidating your debt, make sure the lender is trustworthy and can provide detailed information about interest rates and fees. In addition, look for a company that offers flexible repayment terms and will work with you to create a plan to pay off your balance as quickly as possible. Some creditors may even allow you to refinance again when you're ready, getting rid of your debt.
Don't let your debts get out of control by taking out another loan. Instead, consolidate what you owe for lower interest rates and work toward a better financial future.
The Debt Consolidation Process Explained
I'll run through the process with a credit counselor here but understand that you can do all this yourself, save months of counseling and get it all done in less than a week online.
First, you'll need to put together your spending over the last three months to see where your money is going. Next, a debt counselor will help you determine where you can cut your spending to avoid overspending in the future.
The debt manager will ask for your credit cards, and he will have a massive set of scissors. It only hurts for a moment. Don't try keeping any cards out, not even a small department store card. The credit counselor will probably find it through your credit report, and you may not get the loan.
You'll be left with one emergency card. This will be used for that emergency car repair or hospital visits. Then, together, you and the debt manager will work to combine your debts so that you can pay all accounts together in one monthly payment. Finally, your counselor will find a way to spend all your debts within three to five years.
This is the most considerable disagreement I have with credit counselors. They'll tell you to avoid debt totally and not use any credit cards except in emergencies. However, using credit is the only way to improve your credit, so neglecting it won't help.
You might pay off your debts eventually, but your credit score will still be lackluster, and you'll pay high rates on any loans you need. So instead, improve your credit score by using your credit card each month, only for necessities, and pay it off monthly to avoid interest charges.
Besides getting the credit counseling that will help avoid repeating your bad credit habits, debt consolidation also offers the opportunity to negotiate a lower rate and debt. Your creditors don't want to force you into bankruptcy, where they will likely receive no money.
So your credit counselor is going to try negotiating with your creditors for a lower interest rate and maybe even to lower the amount owed. The debt consolidation process will cost between 3% and 5% of the loan amount. Still, in most cases, the benefits outweigh the costs.
The debt consolidation process can take several months if you work with an agency, but you'll save money in the long run. You save on paying interest on negotiated debt, late fees, and all the individual fees you might have to pay. You sleep better because you're not trying to juggle bills in your head. Getting a personal loan to consolidate your debts will take less than a week and may be a better solution for someone that doesn't need the debt counseling.
What Debt Can Be Consolidated?
Any debt can be consolidated, but there are some rules you want to follow to save as much money as possible. A consolidation loan is just a personal loan. You get the funds deposited into your bank account and use them for whatever you want.
When deciding which debt to consolidate, plan on paying off the debt with the highest interest rate first. That usually means credit cards and maybe a car loan.
You also want to check your rate on the consolidation loan before making the final decision. Checking your rate doesn't affect your credit score, so you can check it on a few different websites to see which gives you the best offer.
Once you know what rate you can get on a debt consolidation loan, you can decide which other debts to pay off. Of course, you'll only want to consolidate loans with a higher interest rate than your consolidation loan. You save money by borrowing at a lower rate to pay off high-rate debt.
Debt Consolidation vs. Debt Settlement
Debt consolidation is NOT debt settlement, and the difference is more important than you might think.
Debt settlement is where you work with a settlement company to negotiate payments with your creditors. Debt settlement companies can sometimes get creditors to knock off thousands from the debt you owe, but there's a catch.
You'll have to stop paying your bills for months for debt settlement to work. That gives the debt settlement company negotiating power over the creditors. It also destroys your credit score, and you'll have trouble getting any loans for years afterward. You'll also be on the hook for thousands of dollars in fees to the debt settlement company. Sometimes the fees are so high that you're not saving that much on your debt.
Is it a Good Idea to Consolidate Your Debt?
Our debt consolidation loan was the only way we could have avoided bankruptcy. Are the interest rates high? Yes. Is it just trading old debt for new? Yes, but interest rates are almost always lower than credit card rates, which means you'll save money.
Of course, avoiding getting into debt in the first place is the better option. In a perfect world, you would have a solid emergency fund you could lean on whenever unexpected expenses arise. Yet, unfortunately, that's not the norm, and sadly when hit with a considerable expense you weren't anticipating, there's a reasonable probability you'll end up charging it on a credit card instead. So, consolidation is your best option unless you want to be paying on those cards for years and losing thousands to interest payments.
Will a Debt Consolidation Loan Hurt Your Credit?
Debt consolidation can help your credit. Applying for a loan doesn't affect your credit score because the lenders do a soft pull on your credit. However, you may notice a slight drop in your credit after getting the loan because you have more debt on your credit report.
Once you start paying off those other debts and credit cards, your credit score will increase within a month or two. And making your new consolidation payments on time will help you build good credit history and improve your score over time.
Using the Debt Consolidation Process for Financial Freedom
Once you've consolidated your loans, your payment is fixed for the next three or five years. Keep to your spending program and check in with your credit counselor if you feel like you're veering off the path.
Your credit report will reflect that you're making payments through a third-party credit agency. As a result, some creditors may think twice about giving you new credit, which is probably good anyway.
You won't have this problem if you go the personal loan route to pay off your debts. Then, creditors will see that you have paid off all your previous debts and payments on a single loan.
Savings from Debt Consolidation Process
Are you committed to your long-term financial goals? Do you want to kick the paycheck-to-paycheck curse and eventually have the freedom to go on vacations and relax in retirement? Are you ready to change any spending habits that may have contributed to your debt?
Unfortunately, the debt consolidation process isn't an easy solution. Still, it can be a great tool to get your finances back on track to work toward reaching your financial goals.
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