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Getting calls from creditors about outstanding debts? Worried about how you’re going to repay what you owe and safeguard your credit? Consider debt consolidation strategies.
These approaches aim to alleviate stress by combining multiple debts into a single payment via a loan or line of credit. Alternatively, you can pursue a debt management plan or — as a worst-case scenario – bankruptcy.
But before opting for a debt consolidation solution, it’s worth it to gather knowledge, understand the process involved, and carefully assess the pluses and minuses.
Debt consolidation explained
Juggling multiple debts from different creditors, such as credit card companies, personal loan lenders, and retail accounts, is challenging. There’s the constant fear of missing payments, damaging your credit score, and incurring additional fees or penalties.
One recommended avenue out of this mess is debt consolidation. This primarily involves obtaining fresh financing to clear all your outstanding debts, streamlining the payment process into a single, more manageable installment, ideally at a lower interest rate.
The beauty of this approach is that you can merge all your unpaid debts into a new loan or line of credit, making it easier to handle.
“This simplifies your financial management, reducing the number of payments you have to make each month, and can potentially lower your total monthly payment,” says Avi Grunwald, CEO of Fair Capital, a debt collection agency in Spring Valley, New York.
Various financial institutions, such as banks, credit unions, and installment loan lenders, offer debt consolidation loans and financing options to choose from, one of which can be a good fit for your circumstances.
Good candidates for debt consolidation
Debt consolidation financing is not a miracle solution for getting rid of debt. But it can be a beneficial option for individuals who can comfortably manage their monthly debt payments but desire a more straightforward approach that involves a single payment, eliminating the need for multiple payments each month.
The critical factor for success in debt consolidation lies in your ability to consistently make the new monthly payments on time and in full. Failure to adhere to the plan and meet the monthly deadlines can lead to further debt accumulation and damage to your credit.
“A worthy prospect for debt consolidation is someone with good credit, steady income, and high-interest debt like credit card debt,” explains personal finance expert Andrew Lokenauth with TheFinanceNewsletter.com.
Debt consolidation may not be the most suitable choice if the new loan doesn’t offer a lower interest rate compared to your current rates. If your debts mostly stem from credit cards, the interest rates on those cards probably exceed what a debt consolidation loan can provide.
For debt consolidation to work best, you should have “a manageable amount of debt and the ability to make consistent payments,” adds Grunwald. “Individuals with poor credit scores – who may not qualify for lower interest rates – and those who are likely to continue accruing new debt after consolidation should steer clear, however.”
Indeed, while a debt consolidation loan simplifies debt repayment, it’s essential to avoid making additional purchases on credit, as this can hinder efficient debt reduction. Without financial discipline, you risk exacerbating your debt problems and damaging your credit.
And if your credit score has been impacted by debt issues, qualifying for lower interest rates on a debt consolidation loan or alternative methods may be tricky.
Good and bad reasons to pursue debt consolidation
By opting for a debt consolidation loan, the burden of making multiple monthly payments transforms into a single, more manageable payment. This simplified approach stands as the primary advantage of this path.
Todd Huettner, president of Huettner Capital in Denver, explains the major benefit here.
“Say you have 5 credit cards with an average rate of 25% for a total balance of $100k, with an annual interest expense of $25,000. If you could consolidate that debt into a single loan at 10%, the annual interest expense would be $10,000. The savings would be $15,000 in a year,” he says.
Grunwald notes that consolidating debts into a single loan with a lower interest rate and a longer term, “your monthly payment could drop significantly, freeing up cash for other needs and saving you money over time.”
That latter point is important, as choosing the right term for your debt consolidation loan can result in lower monthly payments compared to the combined payments you make on your existing loans and debts. Longer repayment periods can make the monthly payments more affordable.
“Debt consolidation can also help you pay off your debt more quickly and improve your credit score over the process,” Lokenauth continues.
A bad reason to pursue debt consolidation is proceeding with the assumption that your debts will be wiped clean. Actually, a debt consolidation loan doesn’t erase what you owe: You remain responsible for fully repaying what you owe on all the loans and debts you consolidate.
Also, it’s important to realize that opting for a debt consolidation loan may lead to paying more in total interest and principal than if you hadn’t consolidated your debts. Also, be cautious, as many of the tempting introductory rates offered by lenders are temporary “teaser rates” that eventually expire, leading to higher rates charged by the lender.
Carefully comparing interest rates and loan terms becomes essential to determine the total interest and fees you will end up paying.
Suggested debt consolidation strategies
Here are several ways you can put debt consolidation to work for you if you qualify:
- A fixed-rate debt consolidation loan. With this loan, your payment remains the same for the life of the loan, offering a predictable repayment schedule and possibly lower interest costs; however, you may incur fees and may require good credit to be eligible. “You want to shop for a debt consolidation loan that has a lower interest rate than the average combined interest rate of all of your credit cards or other debts,” suggests Amy Maliga, a financial educator with Take Charge America in Phoenix. “Once you receive the loan funds, you will pay off all of your outstanding balances and are left with one loan payment each month. This can make it easier to budget and stay organized. In some cases, the loan payment may be less than what you are currently paying each month.” She adds that most traditional banks, online lenders, and credit unions offer debt consolidation loans.
- A 0% APR balance transfer credit card. This is a credit card that offers a promotional 0% interest rate for a limited period – typically the first 12 to 18 months, after which time the rate will adjust much higher. “If you can pay off your debt within that initial timeframe, this can save a lot on interest costs. However, these cards often have high interest rates after the promotional period and usually charge a fee to transfer balances,” cautions Grunwald.
- A home equity loan or home equity line of credit (HELOC). You can tap into your home’s accrued equity and take out either a home equity loan (second mortgage) or HELOC (from which you draw money as needed over a set draw period), using the funds to pay off your higher-interest debts. “The drawback here is that you must use your home as collateral. That means you risk losing your home if you cannot repay,” says Lokenauth.
- 401(k) loan. This option involves borrowing from your retirement savings to pay off your debts. But many experts do not recommend a 401(k) loan, “because, while you are essentially paying interest to yourself, you could miss out on investment growth,” Grunwald says. “Plus, the loan will become due immediately if you leave your job.”
- Debt management plan. This strategy involves working with a credit counseling agency, which will negotiate with creditors to lower your interest rates and payments. Maliga notes that debt management plan clients make a single monthly payment to their agency, which then disburses payments to all your creditors enrolled in the plan. If your interest rates can be lowered, “this allows more of every monthly payment to go toward paying off your principal and helps you pay off the debt in full much more quickly than you could on your own,” she points out.
- Bankruptcy. Bankruptcy is a complex legal procedure in which your consumer debt undergoes restructuring, which may involve debt elimination, payment arrangements, or a combination of both. Bankruptcy can offer a fresh financial start for certain borrowers, but it’s essential to be aware of its drawbacks. “Bankruptcy should be viewed as a strategy when your debts are insurmountable and there is no realistic chance of repaying them in the foreseeable future. It can provide a fresh start, but its consequences are long-lasting,” Grunwald says. Consider that a bankruptcy notation remains on your credit report for seven years, making it challenging to access new credit at reasonable rates during that period. Furthermore, the process itself can be expensive and may result in debts specifically tied to the bankruptcy filing. Hence, it’s advisable to seek guidance from a qualified bankruptcy attorney if possible and only consider bankruptcy as an absolute last resort.
The bottom line
Feeling a bit overwhelmed by bills and red ink? You are not alone, and there are steps you can take to dig out of a debt hole – even a deep one. Explore different options and consult closely with a trusted expert like a personal finance coach, certified financial planner, or attorney.
Remember that debt doesn’t have to be a life sentence. Take charge of the situation now and reclaim your financial freedom.