Carrying multiple debts can get confusing. Paying each debt on time and with high enough payments gets difficult. What happens when you are in over your head? Don’t make the mistake of assuming you must default. Instead, consider debt consolidation.
Debt consolidation is the process of taking out one loan to pay off others. In a sense, you transfer the debt. You are not paying it off. You’ll still have monthly payments and interest, in most cases. It’s often the right solution for consumers with high amounts of debt. However, there are some steps you must take to make sure you don’t end up in the same situation.
The Debt Consolidation Process
Once you admit you are in debt, you must find a loan that can help. Debt consolidation loans come in several forms:
- Installment loan
- Home equity loan
- Low-interest credit card
- Debt management plan
Each option involves the same idea. You borrow money to pay off your current debts. You then make payments on the new loan until you pay it off. The difference is you have 1 payment rather than multiple payments. This can make your debts easier to manage. Oftentimes, it also shortens the time necessary to pay them off.
Each method requires you to complete an application. Credit cards require a simple credit card application. Installment and home equity loans require you to talk to a bank and discuss your options. You can apply for the loan and wait for underwriting to render a decision. If you have no other options, you can consult with a credit counselor to work out a debt management plan.
Common Debt Consolidation Methods
There are two common methods for debt consolidation – the personal loan and the low-interest credit card. With the personal loan, you borrow the money necessary to pay off your debts. When the bank funds the loan, they pay off your current creditors. You then have one payment with a fixed interest rate. Personal loans can have terms that vary between 1 and 7 years.
Some consumers are lucky enough to score a 0% APR credit card. As long as it has a balance high enough to consolidate their debt, it can help. In this case, you use a balance transfer and transfer your other credit card balances over. Each transfer can cost you up to 3% of the balance. You then have a credit card with no accruing interest. If you can pay the balance off before interest accrues, you can save yourself quite a bit of money.
Both options have one large risk – the risk of running up the credit cards. After you pay off your credit cards with other funds, your credit cards are available for use again. But, this just starts the vicious cycle over again. While you should keep your cards open for your credit score. You shouldn’t use them.
What Happens if You Don’t Qualify?
Some consumers are so deep in debt that they don’t qualify for standard debt consolidation. These borrowers often take out a home equity loan. You can usually borrow up to 85% of your home’s value in a home equity loan. Your approval might depend on what debts you pay off. Many approvals are contingent on the disbursement of funds directly to the creditors. This lowers your debt ratio, helping you qualify for the loan. Keep in mind, a home equity loan uses your home as collateral. If you stop making payments, you could lose your home. Home equity loans also stretch out your debt repayment as much as 30 years. This can really increase the amount you pay in interest.
Consumers that can’t qualify for any of the above often turn to a debt management plan. A debt consolidation company works as a 3rd party on your behalf. They negotiate with your current lenders to help lower your balances. They may also negotiate your interest rates. In short, they do the work for you. Instead of making multiple payments, you make one payment to the debt consolidation company. They disburse the funds to the appropriate creditors for you. Keep in mind, if you choose this option, all accounts included in the restructuring will be frozen until they are paid off.
What Should You Consider?
What if you qualify for any of the above procedures? How do you know what’s right? Consider the following issues.
The Cost of Consolidation
No type of debt consolidation comes completely free. You’ll pay somehow. Credit cards charge balance transfer fees and interest at some point. If you have an introductory rate, it’s usually only good for 12-24 months. Installment and home equity loans have origination fees and closing costs. Even debt consolidation companies charge something. Non-profit companies generally charge a set-up fee. They also charge a monthly maintenance fee. For-profit companies usually charge slightly higher fees too.
The Loan Terms
Your ultimate goal is to pay the debt off. You should focus on the loan’s term. A credit card doesn’t have a term. You are given a minimum payment and that’s all you must pay. However, if you want to get out of debt before the interest rate increases, you need a plan. Take the total amount of debt and divide it by the months you get interest free. For example, a 24-month interest free credit card with a $5,000 balance would require payments of $208. If you consistently paid at least that amount, you’d pay the debt off before interest started accruing.
Your other options include terms. Installment loans and home equity loans have a specific term. You have a fixed payment that you must pay for the entire term. Once you pay the loan off, the debt is gone. Home equity loans can have a term up to 30 years, though. This is something to keep in mind. The longer it takes to pay the debts off, the more interest you pay.
Debt management plans often range from 3-6 years, depending on your situation. Remember, while you are in the plan, your credit is frozen. This means you can’t use any of your credit cards during this time. The longer you drag out your payment plan, the longer you must go without credit.
The Interest Rate
Along with the term, you should consider the interest. How much will you pay? With the exception of no-interest credit cards, each option carries interest. Know the interest rate charged and how it affects the total amount you pay.
Looking at the Big Picture
Once you know the answer to the above questions, you must make a decision. Lay all the facts out in front of you.
- How much does each option cost?
- How long will it take to pay off each debt?
- How much interest will you pay over the life of the loan?
There’s no cut and dry answer regarding what is right. Only you know what you can afford and how much interest you are willing to pay.
We suggest opting for the procedure that allows the fastest pay off and least amount of interest.
Staying Out of Debt
Once you start the debt consolidation process, you have a problem. You have to stay out of debt. If you haven’t adopted new habits before you consolidated the debt, this could be hard. We don’t recommend closing your credit cards, though. This could harm your credit. The longer your accounts are open, the higher your credit score. Closing the credit cards could shorten the average account’s age and negatively affect your credit score.
We suggest getting into the habit of paying cash for things. If you can’t pay cash, then you don’t need it. This can take a while to sink it, but it will be worth it. In the beginning, it might be difficult. Not buying things you are used to buying can hurt, but your finances will thank you in the end.
The debt consolidation process can be overwhelming. Look at each option carefully. Consider the costs and the accumulated interest. This way you can choose the option that costs the least and gets you out of debt faster. Each option affects your credit in one way or another. As long as your final goal is to get out of debt, your credit score will benefit in the end.