How Does Debt Consolidation Work?

How Does Debt Consolidation Work?

To fully understand how debt consolidation works, you must first understand what it is. You may look at it as a type of loan that helps you consolidate your debt and make it more manageable. A debt consolidation loan can be very helpful if you are late with your credit card payments or if you have student loans, but these are just a few examples. Debt consolidation can also be a means to save money because it often offers a lower interest rate. Debt consolidation can also serve as a “catch-all” term, as debt settlement and debt management are often referred to as types of debt consolidation as well. Let’s have an even closer look at it.

How does it work?

A good consolidation program serves your specific needs as someone that is carrying debt that’s becoming increasingly unmanageable. The more traditional definition of debt consolidation involves a loan. It is an effort to combine your total amount of debt into one loan payment. The consolidation loan is used to pay off outstanding debt, typically with a higher interest rate that the consolidation loan itself.

Debt settlement (another form of consolidation) includes you or a representative negotiating your debt by making an offer to your creditor. One example of this would be to offer a lump-sum payment that makes up a percentage of your debt, rather than continuing to pay monthly installments on the full balance. This is a very simplified version of the process that will be explained in more detail further in the article.

When should you consider debt consolidation?

Discipline and good calculations can be two very helpful skills if you are struggling with debt. If you combine them with a good debt management plan, you could organize your monthly payments in a much better way. Not everyone can deal with all this on their own, and that is why most people turn to an easier way to pay off debt – debt consolidation and debt management (or debt settlement).

With debt consolidation, you can combine all types of debt into one easy monthly payment. It is a very common method that provides an easier way to handle debt payments. Regardless of whether you are employing a loan to help with your debt, or settling your balances for less than you owe through negotiation, the key concept that ties all these methods together is the ease of only paying one monthly payment. That is the definition of consolidation in this context.

Debt management or Debt settlement usually refers to balance reductions and lower monthly payments via negotiation, and it generally works faster than the other type of debt consolidation, which involves payback on a loan. In both cases, we get the same outcome. Your credit card debt or any other form of a monthly payment is combined into one single payment that aims to help you get out of debt much more easily, and in most cases, more quickly.

What type of debt consolidation is the best for you?

Debt consolidation can be divided into four main types:

Debt management plan (Also known as Debt Settlement)

A fairly common choice because it often includes credit counseling and education programs that help individuals understand and identify the cause of their bad financial situation. The counseling itself isn’t just a one-time solution. A credit counselor can offer many solutions that you can take away and put to good use in the future. It is also very impactful, because more of these programs can eliminate your debt for far less than what you owe, and can be considered a hardship based program. It is worth mentioning that this type of debt consolidation usually takes 2-4 years to eliminate debt, so patience and discipline should be a high priority. That said, 2-4 years is fast compared to the 30-year track most people are on that are making only minimum payments to their creditors.

Balance transfer on credit cards

Some credit card companies offer zero percent balance transfers, but it is hard to qualify for such offers. Your credit score should be a bit over 700 before submitting your application. There are some drawbacks as well because the 0% interest rates often expire after 12-18 months, and some transfer fees may be involved as well. It is advisable to go through all the details before considering a balance transfer.

Personal loan

Personal loans can be provided by banks, and you can use such a loan to pay off your debt. The interest rates are in some cases higher than with credit cards, and that is why personal loans aren’t always considered to be the best way to consolidate debt. A personal loan usually includes an origination fee and is not that easy to get if you have a bad credit score. If your debt-to-income ratio is high, you will probably have very low chances of getting one with a good interest rate. It is also tempting to use the loan for purposes other than paying off debt, which will end up putting you in a worse situation. Many debt settlement programs end up dealing with settling not only credit card debt, but the consolidation loan that was supposed to be used for the credit card debt…

Home equity loan 

Home equity lines of credit come with low-interest rates, but your house will serve as collateral. Some experts would argue that you are transforming unsecured debt (debt without collateral) to secured debt, with a home equity loan. With this approach, it is very important to stay disciplined because your home could be lost if you fail to make payments on time. 

If you are thinking about consolidating your debt, you should take every method into account and figure out what works for you. You should be aware of the loan rates and the amount of time that is needed to pay off your debt, and if you go with a debt relief company, you should pay attention to their reputation. Their BBB rating and whether they are accredited should be your first indicator.

The pros and cons of debt consolidation

Keeping up with all of your monthly payments can obviously be a struggle. It doesn’t only affect you financially, but it can also affect your mental health. When it becomes too much, a good debt relief program can be a lifesaver. While some chose to deal with these problems by using credit cards, it is common knowledge that they are often the source of your financial problems. It can also lead to a point where you are only making minimum payments on your bills while spending the rest on interest rates.

It is very clear that debt consolidation comes with a lot of pros. You aren’t only simplifying your monthly payments but also lowering their cost in the process. Debt settlement companies aim to lower the monthly costs of all your monthly payments with a clear debt relief plan. Ideally,if you go the consolidation loan route, your lender will provide lower interest rates, and you will be saving some money in the process as well.

The cons are also fairly obvious. Paying off credit cards and student loans doesn’t mean you are instantly debt-free. Your debt payment will be divided into monthly installments, and you should be prepared to spend 2-4 years in a good consolidation program to eliminate your debt completely.

One thing is clear. If you are looking for a stress-free way to pay off your debt, consolidation should be something to consider. While it won’t be a simple solution that will remove your debt completely (mortgages and auto loans are usually not eligible), it will help you focus on other things in life by offering a single monthly payment that is manageable and fit for your financial situation. In case you need more information on the subject or need a consultation, feel free to request one.

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