Debt consolidation is a strategy where you roll multiple high-interest debts, such as credit cards, into one single debt. This ensures that you have one loan to pay, which can offer better repayment terms like lower interest rates. Generally, you can have more manageable monthly payments.
When consolidating a debt, you apply for a new loan that can cover the balances of all your existing debts. You can use the new loan to clear all the balances of the previous debts and you’ll be left with only one loan to pay.
This article will discuss how debt consolidation works and how beneficial in can be.
Mechanism Of Debt Consolidation
Debt consolidation is a very straightforward concept. You apply for a new loan, such as a personal loan, a home equity loan, or a balance transfer credit card. The loan should be large enough to pay off any existing loan balance.
Once the loan is approved, you can consolidate debt and pay them off. You’ll now be left with only one new loan to pay. This will have a fixed monthly payment and it will be easier to manage.
For example, you have three credit cards with a combined balance of USD $10,000 and they charge interests rates of 17%, 18%, and 19%. On average, you’d be paying an interest rate of about 18%. However, you can apply for a personal loan with a 10% interest rate, you’ll reduce your interest rate from 18% to 10% and simply your payments to only one monthly payment instead of three.
Considerations For A Debt Consolidation Loan
When looking for a debt consolidation loan, there are several considerations that will help you to get the right loan. They include:
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Loan Type
The most common types of loans used to pay off existing debt are personal loans, 401(k) loans, and balance transfer credit cards. These loans come with different interest rates, and some may require collateral.
You must understand the details of each loan before applying. Think about the long-term impact it may have on your finances. If you’re getting a credit card with a lower introductory rate, then plan to pay it off early enough before the rates rise.
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Loan Terms
There are two types of loans you’ll get: long and short-term. Long-term loans have a longer repayment period hence, you’ll have a lower monthly repayment. However, you may be charged more interest rates for long-term loans. Therefore, you should check on the finer details of your long term.
Short-term loans typically have a higher monthly repayment. However, this doesn’t mean that the interest rates will be higher. To settle for the best loan terms, calculate the total amount you’ll have to pay and your ability to keep up with the monthly payments.
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Collateral
Loans can either be secured or unsecured. Home equity loans are always secured by your home, and the lender can take the collateral if you fail you make your payments. Secured loans are higher than un-secured loans and are suitable if you want to consolidate many loans or a larger amount of debt.
Personal loans and 0 percent APR credit cards are mostly unsecured. They are suitable if you don’t want to risk your assets. However, they’re subject to a higher interest rate than secured loans.
Benefits Of Debt Consolidation
Debt consolidation has several benefits if you’re looking to streamline your repayments and financial management. The benefits include:
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Reduce Interest Rates
One of the main advantages of debt consolidation loans is that you can reduce the interests rates you pay on your existing loans. Instead of having several high-interest loans, you’ll only have one loan with better repayment terms and a lower interest rate. As seen in the previous example, the interest rates were reduced from over 17% to only 10%.
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Simplify Monthly Payments
Another benefit of debt consolidation is that you can streamline your monthly payments and make it more manageable. Instead of having three or four different monthly payments of different loans, you’ll only have one loan and subsequently one monthly payment. This will reduce your chances of missing on payments which can help boost your credit score.
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Have A Fixed Repayment Schedule
Debt consolidation loans such as home equity and personal loans are fixed installments loans. That means you’ll know how much you’ll have to pay monthly and for how long. Therefore, you’ll know exactly when you’ll be debt-free and this can act as a motivation towards paying off your loan.
Conclusion
Paying off your debts and loans is one of the most exciting financial statements you can make. However, it can be challenging if you have several debts to pay off and each have different repayment terms and interest rates. You risk missing on your monthly repayments which can affect your credit.
Fortunately, you can consolidate all these debts into one as discussed in the article. This gives you a more simplified repayment terms and lower rates. Just ensure you understand the type of loan you take, the terms, and collateral needed before taking a loan.
