What Is Debt Consolidation and How Does It Work?
Debt consolidation is a type of refinancing—it occurs when multiple debts are combined into one monthly payment with the goal of lowering your interest rate and streamlining your payments. This is done most often with multiple unsecured, high-interest debts, like credit cards or personal loans. Depending on your financial situation, you may be able to pay down your debts faster and reduce the amount of interest you pay with this route, making that financial mountain easier to climb.
Seems pretty great, right? It can be, but make sure you do your research before taking the leap.
How to Consolidate Your Debt
Debt consolidation can happen in a few different ways:
- Take out a fixed-rate consolidation loan: Pay off your debts with the loan, then pay back the loan in monthly installments.
- Sign up for a 0% APR balance transfer credit card: Merge your credit card debt onto one card.
- Take out a home equity loan: Borrow against the value of your home.
- Take out a 401(k) loan: Borrow against your retirement fund.
Each of these routes merges your debts under one umbrella in their own way. Balance transfer cards and consolidation loans are the most common options. Different lenders and banks offer various loan terms, and your unique situation will play a huge part in how you move forward. You may end up with a higher overall interest rate but shorter loan terms, which could save you money in the long run. However, it’s possible that the amount in interest you’ll pay over the life of the consolidated loan will have you paying more overall, so don’t ignore the fine print.
If you’re a homeowner, you may be able to do this with a home equity loan. Essentially, you use your house as collateral in order to consolidate your debts and pay them back. If your finances are otherwise healthy, this can be a good option that doesn’t disrupt the rest of your life too much. Similarly, a 401(k) loan can be an option, but it also poses a risk. With both of these options, be sure to do your homework ahead of time.
How Does Debt Consolidation Affect Your Credit Score?
When it comes to your high-interest loan payments, you’re likely already familiar with how your credit score comes into play: The more debt you have, the lower your credit score will be.
A debt consolidation loan definitely has an impact on your credit health, but the exact impact varies based on your personal situation. First, think about the payments and interest rate—will it be easier for you to pay on time and in full? If the answer is yes, then you’re in good shape to pursue this option. Keep an eye out if you end up with a higher interest rate, though, as you may be brought down by the weight of those payments.
Nobody likes a hard inquiry, but whenever you open a new line of credit (which is what you’re technically doing with a debt consolidation loan), a hard inquiry will show up on your credit report. Too many hard pulls make lenders see you as a risk, which can hurt your efforts for improving your credit.
The reality of consolidating debt means closing accounts, which can unfortunately bring down your credit score. Your credit score is calculated with a few main factors, which include payment history and the length of your overall credit history. When you close an account, its history basically disappears from your credit report, making it look like you haven’t had credit for nearly as long.
On another note, closing accounts can bring your overall credit limit down, which can increase your credit utilization rate. If creditors see you’re using too much of your available credit, that’s another red flag.
When Should You Consolidate Debt?
While debt consolidation may sound like a pretty sweet deal—who wouldn’t want to go from multiple debt payments to one?—it’s not something to take lightly. Just like any other big financial move, it’s important to do your research and understand your options. As you should with any financial decision, step back and take stock of the situation.
- Gather relevant documents (credit card bills, loan terms, etc.) and note the remaining balances and interest rates.
- Understand where you are in the timeline of your repayments and how much interest you’re paying. For example, if you’re almost done paying off your loans, it may not be worth it to take out a consolidation loan. However, if you’re nowhere near the finish line and you’ve got a sky-high interest rate, it may be a viable option.
- Only move forward with debt consolidation when you understand the fine print and have a clear grasp of your timeline.
When it comes to taking out a home equity loan to consolidate debt, only do so if you’re confident that you’ll be able to pay the loan back in full. The last thing you want to do is put your home in jeopardy. Similarly for a credit card balance transfer, be sure you can manage monthly payments and interest without putting yourself into further debt.
Debt Consolidation vs. Debt Settlement
While you may often hear them talked about together, debt consolidations and debt settlements are different.
A debt settlement occurs when you pay a creditor a negotiated amount to settle your debt—often less than the original amount. This happens after a long stretch of unpaid debt and when your next option is bankruptcy. A debt settlement company can set you up with a plan where you pay off the debt over a set period of time in monthly payments.
Unfortunately, debt settlement poses a big risk to your credit score. It will stay on your credit report for seven years, and this negative mark is a red flag to future creditors. It’s still a better option than bankruptcy—creditors would rather have a partial payment from you than deal with the legal battle of bankruptcy. But when possible, it’s best to avoid a debt settlement.
When you’re struggling to handle your debt, it’s understandable if you feel overwhelmed. A new perspective can help you get a second opinion on your situation and tackle your financial recovery head-on. When you need help with your credit, one of our credit repair advisors can provide the fresh eyes you need to move forward.
from a Credit Expert