Debt consolidation is a way out for borrowers with multiple loans. In a nutshell, it is joining all these debts into one and repaying them with a single monthly payment. Such loans frequently offer lower interest rates which can potentially lead to saving money and hinder debts from piling up more.
Still, not all consolidating offers are the same, and one needs to research each one of them carefully. This article will offer the information to let you answer the question ‘Is debt consolidation a good idea?’
What Is Debt Consolidation?
A debt consolidation loan is a solid way to refinance what you owe. This consists in applying for a loan in an amount equal to all of your debts. When approved, a user is free to use the funds to pay off their balances.
As you deal with your older loans and put them in order, repaying this new loan follows. Debt consolidation loans come with different conditions, terms, and amounts and can be of two types: secured and unsecured (most widespread).
A large spectrum of loans are included in debt refinancing: credit cards, personal loans for various purposes, student loans, and more.
How Debt Consolidation Works
So, a debt consolidation loan works as follows. At first, a user needs to define the amount that would be enough to cover all the loans on them. Then, with this amount in mind, they should make attempts to apply for a debt consolidation loan.
For instance, a user has a few credit cards: a card with a balance of $3,000, a card with $2,000, and a card with $3,000. As often happens with many credit card lenders, they charge a higher interest for debts repaid in over 12 months.
This APR might be nearly twice higher than if you repay within a year. If the user’s credit card APRs are 26%, 15%, and 18%, a debt consolidation loan can reduce all card rates to one rate of nearly 10-15%, depending on variables.
While decreasing the overall amount you owe is not always possible, this can lead to faster debt repayment. In addition, remember that your success will depend on whether you repay the consolidation loan in full and are on time with monthly payments.
Debt Consolidation: Is It A Good Idea?
This is a popular choice if you seek to break free from the obligation to pay off multiple loans, such as credit card debts, at a time and save costs. First and foremost, this is going to simplify the way you handle monthly payments. Instead of many different loan due dates, you get one that is harder to miss. This impacts your credit score positively.
Debt consolidating is especially a good chance for those who have several high-interest loans taken out and can qualify for low interest rates. In this case, the total amount of your debt will go down and be restructured so that you will be able to make payments in the desired size and pay it off quicker.
When Debt Consolidation Isn’t Worth It
The potential downsides of debt consolidation loans include several things, but users are most concerned with the total loan cost. When they look at the loan conditions in-depth, it may turn out that, even with a more favorable interest rate, the price goes up. The rates depend on your:
- Debt-to-income ratio (the lower, the better)
- Income & verification of employment
- Credit score (650 and above, with higher credit scores for getting better interest rates)
- The sum you take out
This needs careful calculation and consideration of loan repaying terms. If this is what you see in your situation, then it might be better to leave debts as they are and strive to become more diligent in repaying them.
Another way consolidating loans can be useless is when they lower credit scores. Closing your old credit cards and accounts makes them drop radically. In addition, a new credit application can decrease credit score if it involves hard inquiry.
Pros Of Debt Consolidation
Having several high-interest personal loans or credit cards doesn’t add to your financial stability. If you find yourself reading this article, you have already figured this out. If carrying many debts is something you are sick and tired of, debt consolidation can help.
Mind, however, that you need to have a good credit score, let’s say, 680 and up, to qualify for the best conditions, such as interest rates and fees. Only in this case, debt consolidation helps you save money.
Let us summarize the benefits of debt consolidation:
Lower Interest Rate
First, it’s worth it to take out a debt consolidation loan because of the chance to pay less interest because of the more affordable interest rate.
As already mentioned, sometimes this works, and sometimes it does not. But if the loan allows you to decrease the interest rate, why not do it? It was estimated that debt consolidation loans offeredan average interest rate of 13.5% to 16% last year, whereas the APR for credit cards reached nearly 19.5%.
It’s also best to check the current interest rates for the preferred type of loan to note how useful the consolidation may be.
Reduce Monthly Payment
Repaying loans becomes cheaper and much easier with debt consolidation loans. In essence, you don’t stretch your debts for long years but rather squeeze them into a convenient timeline. Together with this, shorter payoff time results in paying less for the loan. In other words, monthly payments go down if the loan repayment term is chosen correctly.
Improve Credit Score
Debt consolidation that sums up multiple debt balances has the potential to increase a user’s credit score. In fact, there are two sides of the medal. On the one hand, closing your accounts for credit money can result in a short time credit score drop.
This is a temporary effect, and if you don’t plan to take out new loans soon, there is nothing to worry about. So, in the long run, you are likely to raise your credit score on the condition that you do your best to make monthly payments on time and avoid accumulating new debts over this period.
As a good bonus, the credit utilization ratio might decrease after opening a consolidation loan as well. Since this will increase the overall available credit amount, a decreased ratio is likely to balance the cons of this loan for one’s credit report.
Fixed Repayment Schedule
With debt consolidation loans, you can get a much simpler way to manage loan payments. Users transform their mess of different loan types into one specific schedule, especially when a consolidation loan has a fixed schedule.
This is a true story for most debt consolidation loans. It’s also better to make one monthly payment with a single due date, so you are more sure of not missing the date.
Cons Of Debt Consolidation
Like every other loan, debt consolidation loans can carry some risks and benefits. The cons are the following:
- Creating an illusion of financial well-being.
For some people, lessening the number of loans may be a stimule to go back to using credit cards. Even if they fulfill monthly payments in time, the general amount of debt is likely to go up, and using a debt consolidation loan becomes senseless. Giving in to this temptation just undoes all credit consolidation benefits.
- Charging fees.
ometimes debt consolidation loans require users to pay a fee, e.g., a loan origination fee, prepayment fee, balance transfer fee, and others. It’s best to research the lender’s conditions to see which of them you will need to pay.
- Interest may be even greater.
In case credit score and DTI don’t let you get beneficial conditions on the chosen loan amount, one may even end up paying more than with existing debts.
When You Should Consolidate Your Debt
The right choice of a debt consolidation loan is going to let it improve your credit score and lessen monthly payment if you are able to stick to the loan repayment plan.
One should try to consolidate their debt in one of these cases:
1. Owing large amounts.
The game isn’t worth the candle if your debt isn’t significant but when it’s about big sums of money, filing debt consolidation is reasonable.
2. Your credit score and DTI are acceptable.
With a good and excellent credit score, there are no big charges to fear, so you can hope for better loan conditions and an APR lower than the ones you have right now.
3. You have more than debt consolidation to improve your situation.
Just a debt consolidation loan might not work as one backed up with a tried and true plan to get back in control of your funds. Here belong financial behaviors that one should control as well. If you can do it and know how to get out of debt and not obtain new credit cards, then choosing a debt consolidation loan is best.
On the other hand, it isn’t a good idea if your income is unstable or there is none. It shouldn’t be a stress for your purse to pay off a new monthly payment and afford a living at the same time.
How To Find A Debt Consolidation Loan
Apart from defining the necessary sum to cover all debts, it’s vital to compare lenders to make the right choice. As a rule, online lenders will be most numerous and allow you to prequalify, look at rates for your specific debt consolidation, and at the same time, make no impact on your credit score. Online lenders are most often chosen because of this.
Obtaining a debt consolidation loan with credit unions means you will undergo hard credit pull but can grant low interest. Additionally, banks offer loans to consolidate debts, and those on good terms with a specific bank can receive perks.