Did you know that American household debt is around $14 trillion? Thousands of American households have some form of debt, whether it’s a mortgage, a car loan, credit cards, or another type of loan.
While a small amount of debt is both normal and manageable, large amounts of debt can create big problems. Suddenly, it can become tough to make regular payments and get your loans down.
If you’re in this bucket, you might want to consider debt consolidation. Let’s take a look at what debt consolidation is and how it can help you manage your finances.
What Is Debt Consolidation?
Debt consolidation simply refers to the process of combining several different debts into a single loan. That creates one monthly bill that you can then pay off more easily.
When you consolidate debt, you typically get longer repayment terms. Even though your monthly debt payment is lower, you’ll be paying off the loan for a much longer period of time.
On top of that, you don’t necessarily get a lower interest rate if you consolidate your debt. Sometimes, you could end up paying a higher interest rate on your total loans.
It’s also important to note that debt consolidation loans come with fees for setting up the loan, transferring balances, closing the loan, and annual payments. That means that you can end up paying quite a bit of extra money if you’re not careful.
How Does Debt Consolidation Work?
Now that you know what debt consolidation is, let’s talk about how it works. That way, you’ll be able to see if the process is a good choice for you.
When you consolidate your debt, you take out one large loan to cover all your smaller loans. Instead of making tons of different payments, you just need to make one large payment that covers your entire debt balance.
The exact process you’ll follow to get started getting out of debt with a debt consolidation loan will vary. However, in general, you’ll start by filling out an application.
Once you fill out the application, the lender will check your debt-to-income ratio and take a look at your credit. Then, they’ll request various documents regarding your debt, identity, finances, insurance coverage, and more.
After you submit this information, the lender will evaluate your profile. If you’re a good fit for the program, the lender will approve you for the debt consolidation loan.
In some cases, the lender will pay your loans off immediately and you’ll then pay back the lender. Other times, you’ll get a line of credit that lets you pay the loans off yourself.
Types of Debt Consolidation Options
There are several different debt consolidation options out there, and each one works a little bit differently. To make sure you’re choosing a plan that will benefit you, you need to understand these types of loans.
Firstly, you’ll need to be aware that you can either take out a secured loan or an unsecured loan.
Secured loans mean that you need to put up some form of collateral to receive the loan. If you don’t make payments on your debt consolidation loan, the company can seize your home, car, or other assets.
Alternatively, you can take out an unsecured loan. Even though you don’t need to provide collateral, these loans come with higher interest rates since they’re riskier for the lender.
Now that you understand secured vs unsecured debt consolidation, let’s look at a few different types of loans you can choose from.
Debt Consolidation Loan
One of the most common ways of managing debt with a debt consolidation loan is a debt consolidation loan. These loans can either be secured or unsecured and come from either a bank or a social lender.
Social lenders, while they might seem like an attractive option, aren’t necessarily the right choice. Remember that these peers are running a business and plan to benefit from your debt consolidation, meaning they’re likely to charge high-interest rates.
Credit Card Balance Transfer
Another form of debt consolidation loan is a credit card balance transfer. With this type of consolidation, you move all your credit card debt onto one single card.
Once again, while this might seem like a good plan, it usually comes with transfer fees, a higher interest rate, and harsh penalties if you miss any payments.
Home Equity Line of Credit (HELOC)
Sometimes people take out a home equity line of credit, also called a HELOC. This is a type of secured loan that gets you cash for your home’s current home and uses your home’s current value as collateral.
Keep in mind that with a home equity line of credit you’re trading part of your home for more debt so that you can get rid of your other loans. This method can end up putting you more in debt since it causes you to give up part of your house.
Student Loan Consolidation
The last major type of debt consolidation is student loan consolidation. These loans take all your federal student loans and turn them into one lump payment to make it easier to pay off multiple loans.
Many student loan debt consolidation plans come with some great benefits. They often get you lower interest rates and don’t usually rope you into a longer repayment period.
Is Debt Consolidation a Good Financial Move?
Now that you have a solid understanding of what debt consolidation is, let’s talk about whether or not it’s a good idea. After all, just because you can do something doesn’t mean that you should.
Unless you’re consolidating student loans, debt consolidation isn’t usually a good financial move. Let’s take a look at five reasons why that’s the case.
1. You Can’t Guarantee Lower Interest Rates
When you consolidate a loan, your lender will provide you with a new interest rate based on your credit score and payment behavior. Usually, they offer higher interest rates than the debt you already have.
2. Lower Interest Rates Don’t Stay Low
Sometimes debt consolidation companies offer you a low-interest rate at the beginning of your repayment period. However, that rate usually only applies for a limited amount of time.
These types of interest rates eventually rise and often wind up being higher than the rates on your original loans. That can throw you into further financial problems than when you started!
3. You’ll Be in Debt Longer
If your goal is to get out of debt as soon as possible, then debt consolidation isn’t the best plan. That’s because even though debt consolidation comes with lower monthly payments, it also comes with a longer payment period.
With those extended payment terms, you wind up staying in debt for far longer. And, you wind up paying more on interest than you do on your actual loan.
4. You Don’t Eliminate Debt
Sometimes, people are under the misconception that debt consolidation means debt elimination. They think that by consolidating their debt they can get rid of their financial struggles once and for all.
The trouble is that debt consolidation doesn’t actually mean putting a stop to your debt at all. All it really means is that you move your debt around to make things easier to pay off in the short term.
5. You Don’t Change Your Financial Behavior
If you think that consolidating your debt will change your life, think again. Most of the time, when people consolidate debt, they simply wind up gaining all that debt right back again.
The reason why this happens is that they don’t have a plan to help them spend less money and stick to their budget. As such, they don’t alter their spending behavior in any way.
Instead of making smart financial choices that help them avoid this issue in the future, they simply wind up in deeper debt than when they started. That’s one major reason to avoid debt consolidation!
Does Debt Consolidation Hurt Your Credit Score?
What many people don’t realize about debt consolidation is that it can actually hurt your credit score. That means that even though you pay off your debts with one lump sum, you can wind up putting yourself in a situation where it’s harder for you to get credit in the future.
The reason why this is so important is that credit scores value you having some portion of debt for a long time and then consistently paying that debt down. When you transfer debts into one single lump sum, you damage your debt payment consistency.
As a result, your credit score can take a dive and throw you into a whole new set of issues.
Debt Consolidation vs Debt Settlement
We’ve talked a whole lot about debt consolidation, but that’s not to be confused with debt settlement. These two terms might sound similar, but they’re vastly different.
Unlike debt consolidation, debt settlement means hiring a company to negotiate a payment to your creditors that amount to less than what you owe. The creditors then forgive the remaining debt.
With debt settlement, you might get rid of your overall debt, but you’ll also be responsible for paying the debt settlement company a hefty fee. Those fees often range from 20-25% of your total debt!
On top of that, you usually have to stop paying off your debt. Worse yet, sometimes these debt settlement companies just take your money and leave you on the hook for additional interest payments and late fees rather than helping you settle your debt.
For the most part, debt settlement is a scam. If a debt relief company charges you before they settle your debt or reduce it in any way, they are violating laws set in place by the Federal Trade Commission.
Alternatives to Debt Consolidation
Many people wrongly think that debt consolidation is the only way to pay down their debts, especially if they’ve got a lot of it. However, there are a few different alternatives.
One of the best alternatives to debt consolidation is something called the debt snowball method. This method involves paying off all your debts one by one. Let’s take a closer look at how it works.
Debt Snowball Method
With the debt snowball method, you’ll start by listing out all your debts in order from smallest to largest. Then, focus on paying only the minimum payments on everything except the smallest debt.
For the smallest debt, you’ll put any extra cash you can toward the debt to pay it down as fast as possible. To do this you can start a budget, cut extra spending, pick up a side gig, or find other savvy ways to make money.
After you get rid of the smallest debt, you’ll move on to the second-smallest debt. You’ll start putting all your spare change into that debt while paying only the minimum payments on the rest of the debts.
Once you pay off that debt you move onto the third-smallest debt and so on. With this method, you keep chipping away at your debts until every one of them is finally gone.
Get Started With Effective Debt Management
Debt consolidation is a great solution for individuals who have rising debt that’s getting out of control. It’s a great way to more efficiently manage various debt loads and get your finances back on track.
Whether you choose to use debt consolidation to manage your finances or you want a different type of support service, we can help. Get in touch with our team today and we’ll work with you on debt repayment options.