What is debt consolidation? | The bank rate
Even if you work hard to manage your money the right way, paying off high-interest debt each month can make it difficult to reach your financial goals. No matter how much you owe, it can take months, or even years, to get out of debt.
One way to handle multiple debt payments is to consolidate. Debt consolidation is a form of money management where you pay off existing debt by taking out a new loan, usually through a debt consolidation loan, a balance transfer credit card, or a debt consolidation loan. ” refinancing a student loan, a home equity loan or a HELOC. Here’s what you need to know about debt consolidation and which method might be right for you.
What is debt consolidation?
Debt consolidation is the process of merging multiple debts into one debt. Instead of making separate payments to multiple credit card issuers or lenders each month, you consolidate them into one payment from a single lender, ideally at a lower interest rate.
You can use debt consolidation to merge several types of debt, including:
- Credit card.
- Medical debt.
- Personal loans.
- Student loans.
- Auto loans.
- Payday loans.
Why it matters
While debt consolidation won’t erase your balance, the strategy can make paying off debt easier and cheaper. If you get a low interest rate, you could save hundreds or even thousands of dollars in interest. Managing a single payment can also make it easier to control your bills and avoid late payments, which can hurt your credit.
What Are the Benefits and Risks of Debt Consolidation?
Debt consolidation is not the right choice for everyone; Before consolidating your debt, consider the pros and cons.
- Pay less total interest. If you can consolidate multiple debts with double-digit interest rates into one loan with an interest rate of less than 10%, you could save hundreds of dollars on your loan.
- Simplify the debt repayment process. It can be difficult to keep track of multiple credit card or loan payments each month, especially if they are due on different dates. Taking out a debt consolidation loan makes it easier to plan your month and control your payments.
- Improve your credit score. You might see an increase in your credit score if you consolidate your debt. Paying off credit cards with debt consolidation could lower your credit utilization rate, and your payment history could improve if a debt consolidation loan helps you make more payments on time.
- Pay the upfront fees. Any form of debt consolidation can incur fees, including origination fees, balance transfer fees, or closing costs. You’ll want to weigh these fees against the potential savings before you apply.
- Put guarantees at risk. If you are using any type of secured loan to secure your debt, such as a home equity loan or HELOC, that collateral is subject to foreclosure in the event of late payment.
- Could increase the total cost of debt. Your savings potential with a debt consolidation loan largely depends on how your loan is structured. If you have a similar interest rate but choose a longer repayment term, for example, you will ultimately pay more interest over time.
How to consolidate your debt
No matter what type of debt you are consolidating, there are a number of options to choose from.
Debt Consolidation Loan
Debt consolidation loans are personal loans that combine several loans into one fixed monthly payment. Debt consolidation loans generally have terms of between one and 10 years, and many of them will allow you to consolidate up to $ 50,000.
This option only makes sense if the interest rate on your new loan is lower than the interest rates on your previous loans.
Best for: Borrowers who want a fixed repayment schedule.
Balance Transfer Credit Card
If you have more than one credit card debt, a balance transfer credit card can help you pay off your debt and lower your interest rate. Like a debt consolidation loan, a balance transfer credit card transfers multiple streams of high interest credit card debt to one credit card with a lower interest rate.
Most balance transfer credit cards offer an introductory 0% APR period, which typically lasts 12 to 21 months. If you can manage to pay off all or most of your debt during the introductory period, you could potentially save thousands of dollars in interest payments.
However, if you have a large unpaid balance after the period ends, you might find yourself in more debt later, as balance transfer credit cards tend to have higher interest rates than other forms of credit. debt consolidation.
Best for: Borrowers who can afford to pay off their credit cards quickly.
Student loan refinancing
If you have high-interest student debt, refinancing your student loans could help you get a lower interest rate. Student loan refinancing allows borrowers to consolidate federal and private student loans into one fixed monthly payment on better terms.
While refinancing can be a great way to consolidate your student loans, you will still need to meet the eligibility criteria. Plus, if you refinance federal student loans, you’ll lose federal protections and benefits, like income-tested repayment and deferral options.
Best for: Borrowers with high interest private student loans.
Home equity loan
A home equity loan, often referred to as a second mortgage, allows you to leverage the equity in your home. Most home equity loans have repayment periods of between five and 30 years, and you can typically borrow up to 85% of your home’s value, less any outstanding mortgage balances.
Home equity loans tend to have lower interest rates than credit cards and personal loans because they are secured by your home. The downside is that your home is at risk of foreclosure if you don’t pay off the loan.
Best for: Borrowers with a lot of equity in their home and a stable income.
Home equity line of credit
A Home Equity Line of Credit (HELOC) is a home equity loan that acts like a revolving line of credit. Like a credit card, a HELOC allows you to withdraw funds as needed with a variable interest rate. A HELOC also taps into the equity in your home, so the amount you can borrow depends on the equity in your home.
A HELOC is a long-term loan, with an average withdrawal period – the period during which you can withdraw funds – of 10 years. The repayment period can be up to 20 years, during which time you can no longer borrow against your line of credit.
Best for: Borrowers with high equity in their home who want a long repayment period.
Are Consolidation Loans Harming Your Credit?
Applying for a new loan or a new credit card will result in a thorough investigation of your credit report. This will often cause your credit score to drop slightly, usually 10 points or less. The hard investigation will stay on your credit report for a year before dropping out completely, but it will usually stop affecting your score after six months.
If you already have good or excellent credit, a simple inquiry won’t have a huge impact on your score. But if your score was already on the borderline between bad and good credit, you risk falling back into bad credit territory. Fortunately, your score should recover quickly if you maintain other good credit habits, such as making payments on time and keeping your credit card balances low.
Is it smart to consolidate debt?
Debt consolidation can help you save money on interest and pay off debt faster, but it doesn’t solve the underlying reason for your debt. Before consolidating, consider the internal and external factors that led to your current situation. This will help you avoid similar issues in the future.
The bottom line
If you’re interested in debt consolidation, take the time to consider all of your options and get quotes from several lenders, including credit unions, online banks, and other lenders. Compare interest rates, fees and terms before finalizing your decision.