Are you stuck between making payments on credit cards, payday loans, or even medical bills? Are you struggling to meet your minimum monthly payments? If you’re not able to make a large dent towards paying off your debt, you risk falling further into a cycle of debt – which can deplete your savings and eventually lead to bankruptcy. This is where debt consolidation can help.
So how does debt consolidation work? And is debt consolidation a good idea for your financial situation? If you’re struggling to pay off high interest accounts and asking yourself these questions – you’ve come to the right place. We’ll go over everything you need to know about debt consolidation and debt consolidation loans so you can decide what’s the best move for your finances.
How Does Debt Consolidation Work?
Debt consolidation rolls different forms of high interest rate debt into a single payment. Debt consolidation involves taking out a sizeable loan, called a debt consolidation loan, and using those funds to pay off your other accounts. This way, your debt is merged into one loan and you only have to pay a single monthly payment instead of keeping track of multiple different accounts.
The interest rate on your debt consolidation loan may be lower or higher than the interest rate you’re currently paying on your other accounts. Your credit score, income level, and whether you’re taking out a secured or unsecured loan will affect the interest rates you qualify for.
It’s certainly possible to find yourself paying lower monthly premiums with a debt consolidation loan. Debt consolidation also helps make payments more manageable and easier to pay off. Many people have successfully used this strategy to save money and get out of debt faster.
Does Debt Consolidation Affect Your Credit?
Taking out a debt consolidation loan involves opening up another line of credit. Some types of debt consolidation loans will have implications for your credit score. Other kinds of options may not affect it as much. Your credit score will also play a significant role in determining the type of debt consolidation loan you qualify for as well as the terms of your new loan.
When you apply for a debt consolidation loan, especially if it’s a personal loan or another credit card, it’s a guarantee that creditors will look into your credit score. This involves a hard inquiry that will cause your credit score to slightly dip. On the other hand, other financing options like a home equity loan, won’t have major implications on your credit report.
We’ll go into detail about your options for debt consolidation and how each one will affect your credit score in the next section.
Remember that debt consolidation loans are just another type of loan. It’s important to make your monthly payments on time and try to pay above the monthly minimum amount when possible. This strategy will help you get out of debt faster and is likely to give your credit score a boost as well.
Debt Consolidation Options
Your credit score along with other financial factors will determine which debt consolidation loan is best for your situation. Likewise, different options will have different implications on your credit score. It’s important to be aware of all the pros and cons before you decide your next steps towards managing your debt. Here’s what you should know.
Personal Loans For Debt Consolidation
Best For: Payday loans and credit card debt
Credit Affects: Your credit will be pulled by the institution you decide to work with. Your report will reflect a hard inquiry and your score might slightly dip.
Most personal loans for debt consolidation are unsecured, fixed-rate loans. They come with varying repayment timeframes. Creditors will consider your credit score, income levels, debt-to-income ratio, and other factors when deciding what interest rates and payment terms to offer you.
Pros: You may qualify for a lower interest rate. This could lower your monthly payments and save you money.
Personal loans also come with repayment timelines, which allow you to keep better track of your finances and give you an accurate picture of your future expenses.
Plus, if you’ve maxed out all your credit cards, taking out a personal loan would increase your credit limit – thereby lowering your credit utilization rate and giving your score a boost.
Cons: There’s no guarantee you’ll qualify for a lower interest rate. In fact, you might end up paying more.
Additionally, if you agree to a longer repayment term, you could end up staying in debt longer and paying more money over time.
Some lenders may also hit you with application fees, origination fees, or prepayment penalties. Make sure you read the fine print before you agree to taking about a personal loan.
Debt Management Plans
Best For: Credit card debt
Credit Affects: Your credit report might reflect that you’ve been working with a debt management plan. Even so, there won’t be direct implications on your credit score.
Debt management plans are personalized payment agreements between debtors and creditors. They usually involve third-party credit counseling agencies. Some credit counseling agencies are non-profit organizations whose goals are to help people manage their finances.
Pros: Oftentimes, you’ll work with a non-profit credit counseling agency to develop a debt repayment plan. These professionals may also be able to provide personalized assistance and financial advice to help you get out of debt.
Your counselor may also be able to eliminate fees, lower-interest rates, or negotiate your debt with your creditors. This may result in more manageable payments that can save you money and get you out of debt faster.
Cons: Debt consolidation plans aren’t offered for every kind of debt. They are usually only reserved for credit card debt, although counselors may be able to offer you advice on managing other forms of debt.
You may have to pay an upfront fee to enter a debt consolidation plan. However, these fees are often inexpensive and have the potential to be waived.
The biggest drawback is that you’ll need to close the credit card accounts that are included in your debt repayment plan. This will lower your credit line and dampen your score.
Debt Consolidation Credit Cards
Best For: Credit card debt, payday loans, medical bills, and car loans
Credit Affects: Applying for a new credit card creates a hard inquiry on your report. This will slightly lower your credit score.
Using credit cards to pay off credit card debt may seem counterintuitive. However, credit card debt consolidation is an actual strategy that takes advantage of 0% APR intro-offers on credit cards to pay off higher interest accounts. These credit cards are also called balance transfer cards.
Pros: If you’re able to successfully apply for a lengthy 0% APR introductory period, you’ll inevitably be able to save money if you can pay off your debt before the promotional period ends.
Cons: Credit card companies know that people are keen to use promotional periods for credit card debt consolidation. Oftentimes you’ll be charged a balance transfer fee everytime you pay off one account with your balance transfer card. These fees can range between 3% to 5% of the total balance you transfer.
Balance transfer cards are usually reserved for people with good to excellent credit. You may not qualify if your credit score is lacking.
If you’re unable to pay off your debt in full before the promotional period ends, you’ll be stuck with a higher interest rate on your remaining balance.
Home Equity Loans
Best For: Credit card debt, payday loans, and car loans.
Credit Affects: A home equity loan won’t result in a hard inquiry and therefore won’t have a major impact on your credit score.
A home equity loan allows you to use the equity you have in your home as collateral for a loan. The amount you’re eligible to borrow is determined by the market value of your property. You’ll receive the total amount you qualify for upfront and be able to pay it back over monthly installments.
Pros: Interest rates on home equity loans are typically lower than personal loans or credit cards. Home equity loans are also fixed-interest rate loans, which guarantee that the price you’ll pay each month is locked in – giving you a better idea of your financial commitments.
Cons: A home equity loan requires you to use your home as collateral. If you are unable to keep up with your payments, the situation could result in a foreclosure with your home being seized.
Just like buying a property, a home equity loan comes with closing costs. These can range between 3% to 5% of the amount you’re borrowing.
If you already have a mortgage on your home, taking out a home equity loan results in two separate housing payments each month.
Best For: credit card debt, payday loans, medical bills, and car loans
Credit Affects: A 401k loan won’t result in a hard inquiry and therefore won’t have a major impact on your credit score.
Some companies allow employees to borrow money from their 401k. This is different from a 401k withdrawal because the amount you borrow will need to be paid back within a set timeframe and you will incur interest.
Pros: A 401(k) loan is a popular financing option because they are not counted as debt on your credit report.
Unlike 401(k) withdrawals, you won’t need to pay taxes or fees for withdrawing your funds before your retirement age.
Your interest rate will almost always be lower than rates on credit cards or personal loans. Plus, the interest you pay on your loan goes back into your retirement account.
Your employer might even allow you to repay the loan with automatic paycheck deductions.
Cons: Not every employer allows 401(k) loans and it’s possible that yours may not. Even if your employer does offer 401(k) loans, you’ll need to pay it back in full before you leave your job or else face considerable fees.
Is Debt Consolidation A Good Idea?
After seeing the different types of debt consolidation options available to you, take a minute to weigh the pros and cons of each. Some choices may be more practical or economical. Look into how each option will affect your financial situation.
Will you truly see significant savings? Will your credit score allow you to take out a larger loan? Can you work with a credit card company to get back on track? Ask yourself these questions to decide the best route for your finances.
The Next Steps After Debt Consolidation
Debt consolidation is a useful strategy for managing your payments and taking control of your debt. There are numerous options for debt consolidation loans and each come with different benefits and drawbacks.
It’s a good idea to do the math and price out exactly how much you’ll save for each option. You may even want to work with a professional financial advisor, counselor or planner for advice. It could surprise you to find some choices more economical than others. All in all, debt consolidation can be a useful tactic for helping you take charge of your financial future.