Debt Consolidation

While debt can be a challenge for anyone, households with limited financial resources can find it particularly difficult to manage their debt and regain control over their finances.

This is especially true for individuals who have a hard time budgeting due to low income or lack of financial knowledge. Fortunately, there are several options available to households and individuals struggling with debt. These options include budgeting, debt management plans and much more.

One of the debt relief options available for those who have already gone through credit counseling and understand the options available to them is debt consolidation. This process can decrease monthly payments to a manageable amount, but it comes with certain disadvantages that individuals should comprehend. Read on to learn more about debt consolidation and find out if it is a good option for you.

What is debt consolidation?

Debt consolidation is a process by which an individual obtains a new loan to pay off most, if not all, of his or her consumer debts. Multiple loans or debts are consolidated into one larger loan. Debt consolidation loans typically have better payment terms, such as lower interest rates and manageable monthly payments. However, there are some drawbacks to debt consolidation.

If you only pay the minimum repayment amount on the loan, you will often pay more over the life of the loan than you would have paid if you did not consolidate your debt. This is due to the fact that the repayment period has been extended, which means you will pay more in interest, even if the interest rate is lower than in the previous individual loans.

Additionally, some companies will only offer you a secure loan, which will require you to provide collateral, such as your home or vehicle, in exchange for the loan. Should you fail to repay the loan, the lender will have the right to repossess your vehicle, or your home may go into foreclosure.

Types of Debt Consolidation

Ideally, debt consolidation loans come with reduced monthly payments, lower interest rates or both. With good credit, you may be able to obtain a personal loan or an unsecured loan with set payments and conditions over fixed terms of three or five years. There are two main types of debt consolidation: secured and unsecured loans. Secured loans are those backed by collateral, which can include any of a borrower’s assets, such as a house or a car. Unsecured loans do not require collateral and tend to have higher interest rates than secured loans. These debt consolidation loans can be difficult to obtain but typically offer fixed interest rates lower than most credit cards.

There are many debt consolidation loan options that fall under either the secured or unsecured loan categories. Below are some of the more popular debt consolidation options:

  • Home equity loan – Also referred to as a home-equity installment loan or second mortgage, this type of loan uses the equity in your home as collateral and typically has a low interest rate. Those who own a home usually qualify for loans of this kind, even if their credit scores are relatively low. Home equity loans are a good option for some, as the interest on the loan is tax deductible for those who itemize their deductions. However, failure to make payments on the loan could result in foreclosure on the home.
  • Credit card balance transfer –This debt consolidation strategy involves transferring multiple credit card balances onto one card with a low interest rate. Most credit cards have a balance transfer fee, but individuals with good credit might qualify for a card that offers no balance transfer fees or little to no interest for a period of time.
  • Student loan consolidation – The federal government offers some debt consolidation options for those struggling with student debt. Federal student loan consolidation is a free service, so there are no added fees involved. Most federal loans can be consolidated, including Stafford loans and Perkins loans. Many student loan lenders offer refinancing options on their loans. Private student loan consolidation may involve certain fees.

When is debt consolidation a good option?

Debt consolidation is not a good option for everyone, but it may make sense for those in certain financial circumstances. Those who have multiple debts totaling over $10,000, own accounts with high interest rates or have monthly payments they have difficulty making stand to benefit from debt consolidation.

Debt consolidation is not for those with smaller amounts of debt or individuals who will not be able to pay off their debt within 5 years.

Consolidating debt successfully requires that those with debt meet these requirements:

  • The total debt accrued is no more than 50 percent of the debt owner’s yearly income.
  • The debt owner qualifies for a no-interest or low-interest credit card or debt consolidation loan.
  • The owner of the debt is able to make consistent debt payments.

What are the drawbacks of debt consolidation?

Before choosing debt consolidation as an option, there are potential disadvantages to take into account. Originating a loan always comes with some risks, and it is wise to know the risks that are involved before taking on a new debt.

Each loan has different terms and conditions. Researching and weighing the options available before selecting a debt consolidation method is the best way to ensure a successful debt repayment.

A few general risks involved in debt consolidation to consider are as follows:

  • Longer loan terms – Debt consolidation loans often have longer repayment periods than the original loan. Although the loan may offer lower interest rates and monthly payments, it might cost more in the long run since the debt will take longer to pay off.
  • Damaged credit score – Paying off a debt with a new loan usually has a negative impact on a credit score at first. If the debt owner makes consistent payments on the new loan, he or she might see an improvement in credit score once the debt is paid off. However, missing a payment on a debt consolidation loan will negatively affect a credit score, as missed payments go on credit reports.
  • Loss of assets – Originating a secured loan runs the risk of losing assets when the originator fails to make payments on the loan. Unsecured loans do not run this risk but are harder to find. Home equity loans, for example, use an individual’s home as collateral. If that individual can no longer make payments on the loan, he or she risks a foreclosure on the home.
  • Loss of special terms – Certain loans, such as student loans, come with some special benefits that are lost once the debts are consolidated. Some student loans allow for the deferment of payments during times of financial hardship or while a student is enrolled in school. Consolidating student loans with would mean losing those benefits.

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