What is Debt Consolidation?

Financial Planning hero

Debt consolidation is the process of combining and merging all of the debt that you owe into a single, monthly, recurring payment with a fixed interest rate. It typically involves your unsecured debts like your medical bills or credit card bills.

When you owe money, whether to a bank or to an actual person, it might make you feel like you’re struggling to stay afloat. Credit card bills, mortgage payments, paying back your auto loan bill; a shocking 70% of Americans admit to not being able to pay off their credit, living above their means. What some don’t realize is that there are options like consolidating your debts, which combines all of your payments into having one single, lower interest rate.

While budgeting can help, you could have different bill due dates, different interest rates and different companies to communicate with. If you have good credit, you might want to consider consolidating your debts in order to simplify paying back to your lenders or creditors. Below we have explained what exactly debt consolidation is, and guidelines to see if it is the right fit for you in your financial journey.

According to CNBC, 70% of Americans admit to not being able to pay off their credit card.

The Debt Epidemic      

The word debt typically has a negative connotation surrounding it. However, being able to take out loans in order to pay for something that we can’t afford in the present, but can over time, is helpful in many ways. For some people, it’s how we can go to college, or live in a home. However, when debt builds up and you start owing a lot of money, it can consume our lives and be difficult to climb out of. The debt crisis is something that is affecting a large population of Americans today. With debt consolidation, when your loans start building up and the interest rates start getting confusing, it allows you to combine all of your loans into one single interest rate. However, consolidating your debt is a big decision that requires some background research on the pros and cons before doing. Understanding the meaning and what it entails will help you decide if it’s the right decision for you. Below, we have given the basis of what debt consolidation is, and what to look out for in lenders’ contracts. 

Understanding How Debt Consolidation Works

Debt consolidation typically allows you to combine your unsecured debt and pay it off in one bill. If you are in a position where it is overwhelming to pay for everything that you owe, having a smaller fixed rate is a good way to help you out in the present. Usually, it promises a lower interest rate at the cost of prolonging the time you are in debt. If this is something that you want to consider, the most common way to do so is through a loan. This could be a loan from a bank or other lender. A debt management program might also be able to help you out. A lender is basically now responsible for paying off the debts that you owe, and you are solely responsible for paying the lender at the rate and time that they choose. 

An important thing to note is that debt consolidating should be considered only if you see your financial situation improving in the future. It is basically a safe way out of paying a large sum of interest rates in your current situation. For example, if you are a college student that doesn’t have a significant income, but have a job lined up where you would be able to pay off your debt, debt consolidation would be a route to take. 

Debt Consolidation combines your unsecured debt in order to pay it off in one bill.

Pros and Cons of Debt Consolidation

Debt consolidation isn’t a win-win situation. The contract that a lender gives you, if you’re accepted, can differ from person to person. It’s a good idea to thoroughly understand the rules that come along with it before going through with it, and outweighing the pros and cons. 

Benefits of Debt Consolidation

  • With debt consolidation, you might qualify for a smaller interest rate.
    • When you feel like you cannot pay back all of the interest rates that you owe with your current financial situation, debt consolidation could be a good option. You can negotiate with your creditor to give a smaller loan, keeping in mind that you will be paying them back for a longer amount of time.
  • It isn’t too overwhelming since you only pay through one stream.
    • The only person you have to be in contact with is your new lender. This makes your financial situation less cluttered and confusing when the time to pay comes.
  • You can avoid major credit score damage
    • If you find yourself not being able to pay off your loans, it is much better on your score to consolidate your debts rather than not paying them entirely. Debt consolidation helps you get time to catch up on acquiring money.
  • You are only making one payment each month.
    • You are able to focus on one payment and how you are going to pay it off, rather than calculating your interest rates for several payments you have.

Risks of Debt Consolidation

  • Typically, debt consolidation means that you’ll be in debt for a longer period of time.
    • If you chose to consolidate your debt, it may seem too good to be true. The reality is that you are paying a smaller interest rate in the present but for a longer amount of time, giving the creditor a profit. So, in the long run, you’ll be in debt for a longer amount of time than you would have initially.
  • You’re actually spending more money on interest rates when calculating your overall total.
    • The reason why a creditor accepts to consolidate your debts is because they receive a profit in the long run. A lower interest rate for a longer period of time means that you are giving back more interest in the end. The longer the period that you are paying interest, the higher interest builds up.
  • The initial interest rate that the lender promises might fluctuate, depending on the contract that you sign.
    • Depending on if your loans are on a fixed or variable rate loan, your lender could fluctuate the rates that you owe. If it is a fixed loan, the amount stays constant throughout your entire contract. If it is a variable rate loan, the rate changes depending on the market, which is riskier.
  • Might result in worsening your credit score.
    • If you are late on a debt consolidation payment, your credit score lowers significantly. It also can put you at risk of high credit utilization.

Make sure to keep track of your credit score!

Is Debt Consolidation a Good Idea For You?

If you are worried about not being able to make your next payment, it is a better idea to consolidate your debt rather than being late on a payment. If you have good credit, you could qualify to consolidate your debt. If not, chances are, you might be declined from the process. Debt consolidation could be a good idea when you have high self-discipline and a guarantee that your financial situation is going to improve in the future. This could be either cutting how much you spend or getting a higher-paying job. If you do not see yourself being able to pay back your debts, try the debt settlement route. 

Debt Consolidation vs Debt Settlement

Some people may confuse debt consolidation with debt settlement. Debt settlement is the process of negotiating with your creditor or creditors to pay a lump sum right now that is a fraction of the total money you owe. For example, if you owe someone $10,000, rather than continuing monthly installments to pay it off while still accruing interest, you could settle this debt by offering to pay $5,000 right now. This might be a good alternative for you if you have an acceptable lump sum available to settle with your creditor. However, there may be tax implications for settling for less than you owe. 

While it can be an ideal situation to reduce the amount you owe, debt settlement usually requires a lot of fees to negotiate with the counterparty, takes up to 2-3 years, and can end with the creditor declining to settle. This differs from debt consolidation because it does not involve getting another loan, but they can be used in conjunction with one another.

Making sure to take your credit score and report into consideration when choosing an option is important, along with extensive research on how to get out of debt as soon as you can. Getting out of debt as soon as you can is always the route to take. Just remember, what works for you, might not work for someone else. Debt consolidation allows you to hold off on paying the full amount of interest rates on all of your expenses. During this time, being smart about your money and saving is imperative. 

Everyone’s financial journey is different. Financial literacy typically isn’t taught in school, so don’t feel like you’re the only one behind or confused. There are resources like Mint to teach you the basics of personal financing, and help you start budgeting in order to cut costs when you can. 

Tags:

Leave a Reply