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What is debt consolidation and how do you consolidate your loans?

If you’ve ever requested a loan or credit line, you understand the fear of getting into debt and not being able to get out of the cycle. Struggling or being unable to keep up with payments can cause terrible damage to your financial future, regardless of what caused you to fall behind.

Debt consolidation is an option to pay off your loans, especially when you have several creditors at the same time. This means that you can group several loans into a lump sum amount and pay it off according to your installment agreement. Consolidation can be an excellent way to reduce or simplify your payments, but it’s important to understand how it works. In this complete guide, SABEResPODER breaks down loan consolidation to help you decide if it’s right for you.

What Is the Difference Between Debt Consolidation and Debt Settlement Programs?

First off, it’s important not to confuse debt consolidation with a debt settlement program. Debt settlement programs are offered by for-profit companies that promise to negotiate an agreement with creditors to settle your debts.

However, these programs can lend themselves to scams or at least bad experiences for the following reasons:

  • Debt settlement companies often instruct their customers to stop making their monthly payments to their creditors, which can severely affect their credit score or even lead to lawsuits from their creditors.
  • In debt settlement programs, customers are asked to make monthly transfers to a savings account where they will accumulate enough to cancel out the settlement agreement. For this reason, many people who already couldn’t pay their debts also fail to comply with the requests of these programs and end up abandoning them.
  • Usually, debt-settlement programs first try to negotiate smaller debts, allowing interest and fees on larger debts to increase.
  • No creditor is obliged to negotiate a settlement of their debts, therefore, it’s a real possibility that debt settlement programs will not achieve their purpose even if the client has followed all their instructions.

Because of the above, we recommend debt consolidation over debt settlement programs.

Benefits of Debt Consolidation

Debt consolidation offers a number of benefits, including:

  • It decreases your monthly expenses on debt payments.
  • It simplifies your payments, because instead of making several to different creditors, you will only have to make one a month.
  • You may be able to get a discount on the total amount of your debt.
  • Reducing your credit utilization could improve your credit score.
  • Your credit history can improve, as long as you make payments for the new amount on time.

Disadvantages of Debt Consolidation

It’s important to note that there can be some drawbacks to debt consolidation, such as:

  • It may generate additional costs. In some cases, the lender adds additional charges to the repayment of the consolidated debt, in case you miss a payment.
  • You may be asked to secure the new credit. Sometimes lenders ask for collateral in order to reach an agreement, such as real estate.
  • It increases the total term of your debt. Your monthly payments will decrease after you reach a debt consolidation agreement, but the consequence of this decrease is that the time it will take you to pay your new debt increases.
  • You must apply for a new loan. When you apply for a debt consolidation loan, the lender will perform a new investigation into your credit history and this will lower your credit score.
  • You must open a new account to consolidate debts. For lenders, opening a new account is seen as a risk, so your credit score may decrease.

Types of Debt Consolidation

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Debt consolidation is a useful option for many people who want to pay off their balances. However, it’s important to understand the different options available. MyCreditUnion.gov is a government site that mentions four main types of debt consolidation. Each of these has its own advantages and disadvantages.

Balance transfer card

This type of debt consolidation allows you to transfer balances with high interest rates to a new card with lower interest. With this method, you can pay off the complete balance at a new interest rate but on a shorter period of time. This offers the opportunity to even save some money.

These are some of the advantages of this debt consolidation method:

  • Lower introductory interest rates
  • More funds go toward paying off the principal balance
  • Fewer monthly credit card payments

While this type of debt consolidation may sound attractive, it also has some disadvantages:

  • Interest rates tend to become very high after the introductory period
  • High annual and balance transfer fees
  • Could affect your credit score if your credit card balances are 30% above the credit limit

Unsecured personal loan

Another option to consolidate your debt is to apply for an unsecured personal loan. Approval will depend on your credit history and it’s main advantages include:

  • No collateral required
  • Borrowers usually secure a fixed interest rate
  • Installment payments
  • By decreasing your revolving credit, this type of loan could improve your credit score

The disadvantages of using an unsecured personal loan to consolidate your debt are:

  • High interest rates, due to lack of collateral
  • Shorter repayment terms, also because the loan is unsecured
  • Additional charges, such as loan origination fee, may apply

401(k) loan

If your employer offers a 401(k) retirement plan that allows you to borrow funds from your own savings, this could be a debt consolidation option for you. Here are some of the benefits of this type of consolidation:

  • Lower interest rates
  • No minimum credit score requirements
  • Won’t affect your credit score
  • No application requirements
  • Allows you to set up automatic payments from your paycheck

This consolidation option sounds very attractive, but it also comes with its own disadvantages:

  • If your employment ends, you may have to pay off the balance within 60 days
  • Your retirement funds won’t earn interest on the money that you borrow
  • Failing to pay off the balance on time may result in early distribution penalties and tax consequences

Home equity line of credit

A Home Equity Line Of Credit, or HELOC, allows you to borrow money against the equity that you’ve built on your home. By using your house as collateral, this revolving line of credit is a debt consolidation option. Its advantages are:

  • Lower interest rates
  • These are usually tax-deductible interest payments
  • Longer repayment terms, since your home is collateral for this loan

These are the disadvantages of a HELOC:

  • It requires a collateral, which is usually your own home
  • Could incur in closing costs and other fees
  • May result in foreclosure if you don’t pay on time

How to Consolidate Debts

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If after analyzing the pros and cons, you come to the conclusion that your best option is to consolidate debts, consider following these steps:

Step 1. Analyze your financial situation

To properly understand your situation, it’s a good idea to check your credit score and clarify what your total income and debt are. You should make a list of all your loan amounts that includes interest rates and monthly payments.

Step 2. Consider the advantages and disadvantages

Before you sign the debt consolidation loan contract, reconsider the advantages and disadvantages of this option. Remember that consolidating debts is not equivalent to eliminating your debts; what you're doing is restructuring the payment of your debts.

Step 3. Analyze your options

Once your financial situation is clear to you, you can start looking for a specific debt consolidation loan. Some creditors offer secured loans with lower interest rates, but keep in mind that this option can jeopardize the asset you're using as collateral, so be extra careful!

Step 4. Negotiate

Once you've decided on your best option for consolidating debt, go to your creditor or debt collector to negotiate your consolidation plan. Remember that it is important to commit to making all your monthly payments on time.

Frequently Asked Questions

What are the requirements to consolidate your debt?

Debt consolidation requirements vary from one method to another. Options like a HELOC require a collateral, while other options offer unsecured loans. Once you’ve decided on a consolidation method, remember to confirm the terms with your financial institution to make sure you meet the requirements.

What is the cost of the process?

Aside from the closing costs of a HELOC, debt consolidation loans charge interests and many times you’ll also have to pay what is known as “points.” According to MyCreditUnion.gov, each point is the equivalent of one percent of the total amount that you borrow. 

Despite these costs, debt consolidation can have big advantages to help you pay off debt in an easy and efficient way.

Debt Consolidation: An Option to Consider

As you’ve seen, consolidation is one of the best options to get out of the debt cycle. We hope that this guide helped you understand what consolidation means and decide if it’s the right option for you. 

If you have questions about this or other financial topics, feel free to contact our team via chat. At SABEResPODER, we’re always happy to help answer your questions and empower you with knowledge!