In a nutshell, debt consolidation is when you put all your debts into one lump sum. Debt consolidation can work if you have good credit, if the balance isn’t too high and if you’re really committed to paying it off.
How Does Debt Consolidation Work?
In financial terms, debt consolidation is a process where high-interest debts are rolled under a single, lower interest loan. Total debt can be reorganized and reduced, which can lead to a faster pay-off.
Keep in mind that debt consolidation in itself will not solve all debt problems. You will still need to practice sound financial habits, i.e., living within your means. What’s more, it’s not the best way to deal with a huge debt that has gotten out of hand.
Debt consolidation is great if the total debt balance is still manageable, and if you’re just looking to reorganize all your bills, each with their own interest rate and due date under a single, more manageable loan platform.
Debt Consolidation and You
There are currently 2 debt consolidation options you should know about. Both of them operate under the same premise that you’ll end up with only one monthly bill to pay.
A 0% Interest Balance Transfer. The balance is usually transferred over to a credit card. The card company offers a promotional rate for you to be able to pay the balance in full quicker.
A Fixed Rate Personal Loan. A 2-step process that involves you taking a loan to pay off the total debt, then paying back the loan in installments over an agreed period of time.
You may also take out a 401(k) or home equity loan to pay off the debt but this is a risky affair that may cause a negative impact to your retirement or property. In considering debt consolidation, you’ll need to factor in your debt-to-income ratio, your profile and credit score.
As a general rule, debt consolidations are a viable option if you have the following:
– Your current cash flow can cover the monthly payments consistently
– You can get a 0% credit card balance transfer or a loan that has a lower interest rate
– The total debt balance is not more than 50 percent of your income
– You have a sound financial plan that ensures this won’t happen again
Here’s what you need to do first- add up all unsecured debts such as personal loans, medical debts and credit card balances. Do a side-by-side comparison with your gross annual salary. If the total debt is half than the annual income and if you can pay off the debt within 5 years, then a debt consolidation plan is a great fit. For example, if you have 4 debt balances from credit cards that have varying interest rates and you have a good credit because you pay them all on time, then you may qualify for a debt consolidation plan that has a significantly lower interest rate.
A loan can also show you that it’s possible to pay off your debt in a set amount of time. You can be sure that a 3-yr loan will be successfully paid off as long as you pay the recommended amount on time. In a credit card debt, paying only the minimum means you’ll be stuck paying the debt for months or even years, and in the end you’ll be paying a lot more than what you borrowed in the first place.
When You Should Not Opt For Debt Consolidation
If the current debt can be paid off within a year and you only save a little bit by consolidating, then it’s probably better to stick to the original plan. You can come up with your own debt payment method such as the debt avalanche or the debt snowball.
If the debt you owe is more than 50% of your total income and if you won’t be able to pay off that balance in the span of 5 years, then it would be better to seek debt relief instead of consolidation.
Debt settlement companies can negotiate with the creditors for a lower debt balance at the cost of them getting a percentage of those savings. The downside is that this can take years and your credit score will suffer. In some instances filing for bankruptcy may be a quicker and more affordable option.
Credit counseling companies offer debt management plans that could reduce the interest rates on your credit card balances. Payment is made to the agency which gets passed on to the creditors. The downside is that you won’t be able to use that credit card while you’re on the debt management program.