Debt Consolidation loans are the typical process of paying off various debts with a new loan or balance transfer credit card—frequently at a reduced interest rate.
Such a process of consolidating debt with a personal loan includes utilizing the proceeds to pay off each individual loan. While oftentimes lenders provide specialized debt consolidation loans, a person can essentially utilize the most standard personal loans for debt consolidation. For the same, most lenders pay off loans on behalf of the borrower, while others usually disburse the proceeds so the borrower can eventually make the payments themselves.
With a balance transfer credit card, qualified borrowers generally get access to a 0% introductory APR for a period varying between six months and two years. The borrower can essentially identify the balances they possibly want to transfer when opening the card or transfer the balances post the provider issues any card.
How Does Debt Consolidation Work?
Debt consolidation loans work by merging all of existing debt into a single loan. Based on the terms of the new loan, it could assist to avail a lower monthly payment, pay off the debt sooner, enhance the credit score or just simplify financial life.
Debt consolidation is a three-step process:
- Take out a new loan
- Use the new loan to pay off your old debts
- Pay off the new loan
For instance, one must say that they have $20,000 in respective credit card debt split among three different cards, each with a rate of interest almost above 20%. If a person takes out a $20,000 personal loan with a rate of interest of 10% along with a five-year term length, one could easily pay off that debt faster along with saving capital on interest.
Is Debt Consolidation a Good Idea?
Debt consolidation is typically a wise idea for borrowers who have various high-interest loans. Nonetheless, it may possibly be only feasible if the credit score has potentially increased ever since applying for the original loans. If the credit score isn’t high enough to qualify for a reduced interest rate, it might not make sense to consolidate the debts.
One may also want to think twice about debt consolidation if a person has addressed the underlying problems that led to your current debts, like overspending. To pay off multiple credit cards with debt consolidation loans is not an excuse to usually run up the balances again, along with it can potentially lead to more substantial financial issues down the line.
Cons of Debt Consolidation
A debt consolidation loan or any balance transfer credit card may possibly seem such as a good way to align any debt payoff. That being mentioned, there are certain risks as well as any disadvantages highly associated with such a strategy.
1. May Come With Added Costs
Taking out a debt consolidation loan may involve additional fees such as the origination fees, balance transfer fees, closing costs and annual fees. When shopping for a lender, ensure to understand the actual cost of each debt consolidation loan prior to signing on the dotted line.
2. Could Raise Your Interest Rate
If a person qualifies for a reduced rate of interest, debt consolidation can be a wise decision. Nonetheless, if a person’s credit score isn’t high enough to access the most competitive rates, one might be stuck with a rate that’s elevated than on the current debts. This would also mean paying origination fees, in addition, with increased interest over the life of the loan.
3. You May Pay More In Interest Over Time
Even Though the rate of interest goes substantially down when consolidating, a person could also pay more in interest over a certain period of the loan. When an individual consolidates debt, the repayment timeline begins from day one and might also extend as long as seven years. The overall monthly payment may be lowered than they’re utilized to, nonetheless, interest will additionally upgrade for a longer period of time.
To sidestep such an issue, budget for monthly payments that would necessarily exceed the minimum loan payment. Such a way, one can take high advantage of such benefits of a debt consolidation loan while avoiding the overall added interest.
4. You Risk Missing Payments
A possibility of missing payments on debt consolidation loans—or any other loans—can cause major damage to the credit score; it might also be subjected to added fees. For the purpose of avoiding this, review the budget to make sure one can comfortably cover the novel payment. However, once to consolidate the debts, take benefits of autopay or any other important tools that can probably assist to avoid any missed payments. In addition, if a person thinks one may miss an upcoming payment, always communicate that to the lender as soon as possible.
5. Doesn’t Solve Underlying Financial Issues
Consolidating debt can simplify payments however it doesn’t address any underlying financial habits that led to those debts in the foremost place. In addition, numerous borrowers who take advantage of debt consolidation loans find themselves in deeper debt as they didn’t curb their spending and continued to build debt. Thus, if a person is considering debt consolidation to pay off multiple maxed-out credit cards, ensure to take time to develop healthy financial habits.
6. May Encourage Increased Spending
Similarly, paying off credit cards and other lines of credit with a debt consolidation loan may create the illusion of having more money than you actually have. It’s easy for borrowers to fall into the trap of paying off debts, only to find their balances have climbed once again.
Make a budget to lower spending as well as to stay on top of payments so one doesn’t end up racking up more debt than one started with.