What is Debt Consolidation?
Debt consolidation is actually a financial management strategy whereby a debtor takes one loan to pay off two or more loans. This strategy is usually adopted by people having different loans with varying high interest rates thereby making it difficult for them to meet their monthly obligations. Debt consolidation loan covers different types of loans such as personal loan, car loans, student loans, medical bills, credit card balances and even payday loans. It has to be noted that debt consolidation loan does not cover your mortgage loan. If you have difficulty in meeting up with your mortgage loan repayment, you may need to renegotiate with your lender.
How does debt consolidation loan work?
It is very simple. Just as mentioned above, it is possible you are having different debts such as credit card balances, personal loan and possibly student loan. The interest rates and the repayment terms of these loans will definitely be different. This may create a challenge of having to keep up with paying different amounts at different times to different creditors every month. As a result of the high interest rates you are paying on these existing debts, you may even find it difficult to meet up with the monthly payments. This may lead to late payment at times. Apart from the fact that late payments will attract penalty fee, it will also have adverse effects on your credit score. So for this reason, you may decide to take one new loan from a debt consolidation company which may be a bank or a credit union. If the debt consolidation loan is approved, you will use the proceeds to pay off your existing debts. So instead of servicing two or more debts at a time, you now have just one loan. This will make it easier for you to manage.
Let’s look at an example to demonstrate how debt consolidation loan works.
Daniel has the following debt portfolio at as the end of May 2017”
Credit card balance of $5,000 with 16% apr. Monthly repayment is $400
Auto loan of $3,500 with 12% apr. Monthly repayment is $150
Student Loan of $20,000 with 13.5% apr and monthly repayment of $850
Total monthly repayment amounts to $1,400
It is possible that Daniel is not finding it easy to pay the $1,400 every month apart from the additional challenge of paying different amount to different creditors at different times. To make life easier for him, he may resort to obtaining debt consolidation loan of $28,500 at 11% apr with monthly payment of $1,200. With this new arrangement, Daniel will be able to pay off all his existing loans. At the same time, he is able to get the loan at a lower interest rate while his monthly loan repayment drops by $200. To make things easier, he will not need to be paying the three creditors every month any longer. The new $1,200 monthly repayment now goes to the debt consolidation loan company. This seems to be a better arrangement indeed.
Debt consolidation loan has many advantages but it is not a thing you should rush into. You need to find out if this arrangement will work for you. You can actually get free advice on debt consolidation from credit counsellors who are certified and highly experienced. They will take you through free credit counselling sessions where they will teach you how you can work with debt consolidation agencies. You will be able to see clearly both the advantages and disadvantages of debt consolidation and other method you can employ in paying off your debt.
Types of debt consolidation loans
Debt consolidation loans can be broadly categorised into two namely; secured debt consolidation loans and unsecured debt consolidation loans
Secured debt consolidation loans: You need to provide collateral as a security before you can be granted this type of debt consolidation loan. It is usually called home equity loan because the loan is secured with your personal equity in your home. Therefore, the amount you will be granted will largely depend on your personal home equity. Lenders may not be willing to loan you 100% of your home equity but you may be able to access up to 80% of it. It is very important that you don’t default in repayment of your secured debt consolidation loan as your home is used as security. Otherwise you stand the risk of losing your home to your lender. As a result of the collateral you are providing, this makes the loan easier to obtain than unsecured debt consolidation loans. You don’t necessarily need to have excellent credit score before you can be granted secured debt consolidation loan. In case of any default, the lender can easily fall back on your home. Another benefit you can enjoy with secured debt consolidation loan is the low interest rate. The loan is consider low risk because of the collateral and this normally reflects in the interest rates you will be offered.
Unsecured debt consolidation loans. This can come in form of personal loan or a line of credit. This type of debt consolidation loan does not require any collateral. However, it is not easily accessible. Before you can be considered for unsecured debt consolidation loan, you must have a good credit history and excellent credit score. Because you are not providing any collateral, the lender may like to factor in the risk factor by way of charging high interest rates. If you don’t want to be burdened with a high interest rate, you may be able to secure the loan at a more affordable rate if you can provide someone to co-sign the loan for you. The co-signor is expected to have a good or excellent credit score too. Because of the implications of co-signing a loan, it may be difficult to find a person who will be willing to act in that capacity. If anyone co-signs the loan for you, that person automatically becomes your guarantor. In case of any default in payment, the person will be held responsible for the full payment of the loan balance. You can approach your family members, close friends or relations to co-sign the loan for you. Before anyone will be ready to stick his neck in front for you, you must be a creditworthy somebody. Otherwise, no one will like to take that risk no matter how close the person may be to you.
Advantages of Debt Consolidation
Reduced interest rate through negotiation with your creditors or debt collection agency: One of the main reasons people take debt consolidation loan is to be able to enjoy lower interest rate. Interest rates on credit cards can be extremely high at times. If you have two or more debts like that, it may become a burden to you. The problem about loans with high interest rates is that, your monthly payments may not have much impact on the principal. You will realise that what you pay monthly can only pay a small amount from the principal while the chunk goes to the payment of interest charges. That is why you see many people struggling with debts all the days of their lives. It is not automatic that debt consolidation will result to paying less interest rate. You need to negotiate the rate with your debt consolidation company. If your debt consolidation arrangement does not lead to lower interest rate, then it is not a worthwhile exercise.
Read Also: See How High Interest Rate Is Killing You
Reduced monthly payment: Just like the example given above, before Daniel consolidated his debts, he was paying as much as $1,400 per month. But after he consolidated the loans, he was able to lower his monthly payment to $1,200. The difference of $200 may seem small to some people, but it can make somebody like Daniel to miss a payment. If you want to take debt consolidation loan, it is important that you settle for an amount that you can afford to pay comfortably every month so that you won’t need to miss any payment.
Single monthly payment: With debt consolidation loan, you are able to pays your creditors thereby helping you eliminating missed or late payments. In case debt consolidation does not work out for you, you can actually consider engaging debt settlement agency. In this case, you still maintain all your existing debts. But instead of paying your creditors individually, you will just need to make a single payment to the debt management company. The debt settlement company will then pay all your creditors. They can also help you renegotiate the interest rates you are paying on the loans. The problem with debt settlement arrangement is that, it can hurt your credit score. Therefore, single monthly payment is better under debt consolidation.
Accelerated debt pay-off: With good arrangement and planning, debt consolidation should be able to help you get out of debt faster. However, you may not be able to achieve this if you restrict yourself to paying the minimum every month. If you want to get out of debt faster, you can decide to maintain the amount you were paying as monthly payment before the debt consolidation. With lower interest rate, a greater portion of the monthly payment will be going towards the principal repayment. If the amount you pay monthly is too small, that means you will need to stretch the loan for a longer period. At the end of the day, what you will pay as interest on the loan may offset the effects of lower interest rate you enjoy. Also, if you want to pay off your debt quickly, you need to avoid additional debt. You should be willing to change your spending habits. You need to make the repayment of the debt your priority. This might require that you temporarily deny yourself of some pleasure. You may decide to skip or reduce your vacation trips. Any savings you make on such expenses should be diverted to paying down your loan. Any financial windfall such as unexpected gifts, tax rebates and bonuses can be applied towards the loan repayment. If you can adopt these measures, before you know it, you are totally out of debt. You will know how sweet it is to be debt free.
Read Also: You Can Pay off Debt With These Strategies
Reduced stress: Debt can actually create stress and tension within a family. Any time you receive a call or letter from a creditor or collector, you don’t feel happy. It doesn’t matter whether you are expecting the call or not. Imagine your child approach you to ask for something immediately after you received the call, if you are unable to control your emotion, you can easily transfer your aggression to him or her. Even though debt consolidation does not take away the loan immediately, at least, you won’t receive those unpleasant collection calls or letters again. You can live peaceably without the thought of someone calling you in respect of debts.
Improved credit score: Debt consolidation can actually help you increase your credit score. When you pay off your existing creditors; the debts will be reported paid in your credit report. As you keep paying your debt consolidation loan without defaulting, you will see your credit score increasing over time. Some people think that credit score is only useful for people seeking loans or people that want to apply for a new credit card. It is much more useful than that. If you have a good credit score, you will be able to enjoy favourable insurance quotes. It increases your chance of getting a good new apartment and your employability as some landlords and employers will like to check your credit history.
Access to profession advice: Debt consolidation loan companies are in a better position to offer you advise that can help you make a good decision about your loans. They can provide debt counselling that can help you manage your debts in order to avoid bankruptcy. Rushing to file for bankruptcy may not be a solution to your financial problem. We know that the record of bankruptcy can stay as long as 10 years in your credit report. Even, if debt consolidation is not suitable for your situation, they can offer you a better option. For example, debt management may be all you need. Debt management is an unofficial arrangement with your creditors to find a better way on how you can pay down your loans. This may involve negotiating for a lower interest rate or waiving of late payment penalty fee. Since your creditors don’t want to lose their money either, you may be able to reach a compromise that will be beneficial to both parties. As part of your debt management strategies, you may need to adjust your lifestyle in such a way that will make it easy for you to pay off your debts. For instance, instead of eating in restaurants, you may decide to be cooking your meal by yourself. This alone can save you some bucks.
Meanwhile you need to beware of fake debt consolidation scammers who are out to take undue advantage of people who are desperate about getting out of debt. If you search the internet, you will come across a lot of them. Some of them usually demand for upfront fee when they are yet to offer any service. They may even promise you that they will help you lower your interest rates by certain per cent or that they will help you beg your creditors for debt forgiveness. The truth is that, no creditor is under any obligation to accept any negotiation for reduced interest rate or debt forgiveness. Creditors have that prerogative to decide which arrangement is best for them. Don’t fall a victim of debt consolidation scammers as this will further drag you into debt. Beware!
In conclusion, as you are getting out of debt, it is important that you abstain from those things or habits that pushed you into debts in the first place. It is easier to accumulate debts but it is not easy to get out of it.