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The best way to consolidate debt depends on your personal financial situation and preferences
With so much going on in our lives it’s easy to get swamped with debt. Experian’s 2019 consumer debt study estimated that Americans have a $90,460 average personal debt.
We have to admit it. Consumer debt hit record highs in recent years. For that reason, many are now searching for a way to solve their debt issues. And debt consolidation is a great way to do that.
But what’s the best way to consolidate debt? Unfortunately, there isn’t a straightforward answer to that. It depends on your specific financial situation.
Factors like your credit score, your debt repayment history, your debt to income ratio, your personal financial preferences, and more. All of these influence the way you can consolidate your debt.
Before you decide how to perform your debt consolidation let’s explore a few things. First, let’s begin with the basics.
What is Debt Consolidation?
The main idea of debt consolidation, also known as loan consolidation, is simple.
You want to combine all your current existing loans into a new, single loan. To do that you need to take out one new loan that you use to pay all your existing smaller loans.
In this way, you now have only one monthly payment to worry about. You can consolidate all kinds of loans with debt consolidation.
The typical examples are high-interest credit card balances, smaller personal loans, overdraft balances, payday loans, and other existing high-interest debt.
Naturally, different loans are often with different providers. Moreover, each loan has its own repayment terms and conditions.
So you will have to make separate payments towards each loan as you agreed initially when you signed up. To solve that problem you simply sign up for a new loan with new terms and conditions.
Then you use the money from this new loan to pay out your existing loans. In most cases, the company that gives you the debt consolidation loan can do this on your behalf.
The result is that now you are responsible for making only one set monthly payment towards a single lender and all your other debts are covered.
What Are the Benefits of Consolidating Your Loans?
The benefits of loan consolidation are many. Here are some of them:
- Debt consolidation can simplify your finance. You have to make only one payment to a single provider.
- It can save you money on interest. That can happen when you get a new loan with lower interest to cover other high-interest debt.
- You can repay your debt faster.
- The total debt amount you have can decrease.
- You can have smaller monthly installments on your new loan.
However, all of these benefits occur when you use debt consolidation in the right way. Essentially when you perform debt consolidation you want to achieve one of these two things
Pay Off Your Debt Easier
First, you want to make it easier for you to track and repay your debt. When you have multiple loans, for example, 5 credit card balances, it is stressful and tedious to track all of them. Each loan despite its form has a different due date and different repayment terms.
On top of that, the amount you pay each month can differ. Sooner or later you will forget to pay on time or pay the wrong amount. This can incur hefty late fee charges and affect negatively your credit score. So you want to avoid that.
By consolidating your debt you can get rid of all the mental pressure that arises when you try to juggle multiple loans.
Debt consolidation can result in you paying slightly more than the original combined amount you owe. Nevertheless, this is often worth it when you consider your peace of mind and mental health.
Save Money with Debt Consolidation
The second instance when debt consolidation would make perfect sense is if you save money. If your credit score has improved it is worth checking the interest rate you can get on a new debt consolidation loan.
You can do this fast and completely free without hurting your credit score on comparison sites like smarter loans.
Still, to ensure you save money you should calculate all the costs carefully. Sometimes the longer repayment period and the origination fee of a new loan can mean you pay more in the end, despite the lower interest rate.
Debt Consolidation Example
Of course, it is best if you can simplify your payments and save money at the same time. Here is the perfect example of a debt consolidation that will do both:
1. You owe a total of $10,000 in combined debt that needs to be repaid in 3 years with an 18 % average annual fixed interest rate. You will need to pay a total of $15,400 ($10,000 + $5,400 in interest).
Your montly installment will be an average of $428 for all debts combined. But you will need to spread that amount between multiple lenders.
So you will have to make multiple payments with different interest rates, on different dates, and for different amounts. And it is possible of these vary slightly each month. So your job gets awfully complicated.
2. You can get a new debt consolidation loan that needs to be repaid in 4 years. It has an 11% annual fixed interest rate, but also an origination fee of $500.
Despite the origination fee and the longer repayment period, the total you would pay is $14,900 ($10,000 + $4,400 in interest + $500 origination fee).
But that is not all. Your montly installment will be smaller as well. It will be a single, fixed montly payment of $310. In this example, you would safe money and your life would be easier by having only one lower payment to look after. Two birds with one stone.
So if that is your case I encourage you to go ahead and get your debt consolidation loan. However, the world is not so perfect and there can be instances when it doesn’t make sense to do that.
Who Should Avoid Debt Consolidation
Debt consolidation sounds great at first glance. Lower interest rate and simplified repayment. Who doesn’t want that? However, there are some downsides and pitfalls of debt consolidation you should be aware of. So is it a good idea to consolidate your debt?
In an ideal world, you will get better terms and interest rate on a new loan. Yet, this is not possible for many individuals. If you don’t have a good credit score or if your credit score went down recently you will have a hard time getting a lower interest rate loan.
Still, it is worth checking. As mentioned, you can always go to comparison sites like guidetolenders and see some free quotes. If you simply compare debt consolidation quotes it is not considered a credit check. So it wouldn’t affect your credit score and lower it even further.
Anyways, if the interest rate of the debt consolidation loan is higher, the repayment period is longer and the origination fee is huge, then it is not a good idea to consolidate debt. Why pay so much more when you are already having a hard time paying off your debt?
Moreover, many lenders have prepayment penalties. That means you will need to pay a fee if you want to repay your loans sooner than agreed. These fees can be high and make a debt consolidation even a worse decision.
You should also bear in mind another important thing. When you perform a debt consolidation this will slightly lower your credit score in the short term. Regardless if you have a good or bad credit score at the moment.
When you close multiple existing loans and open a new one, this is viewed negatively by the credit bureaus. New loans mean higher risk in their eyes. However, in the long haul, your credit score will bounce back.
Furthermore, if you improve your credit repayment behavior your credit score would even increase. That is a big advantage for people with poor credit history.
Read more: How To Increase Credit Score to 800
What Kinds of Debt Can You Consolidate?
In general, a debt consolidation is a form of refinancing. That means you get out a new loan with new terms and conditions to cover an existing one.
So basically you need one thing. The new loan amount should be enough to cover the combined amount of your original loans.
There isn’t any restriction in regard to the type of loans you can consolidate. You should just be able to get enough money with the new loan to pay off your current loans.
Here are some of the most common loans you can consolidate:
Student Loan Debt Consolidation
Student loans can be worth consolidating. When you finally graduate you may find yourself with multiple student loans. Moreover, these loans can have high-interest rates.
At the time you got the student loan you probably didn’t have much credit history (if any). Now, when you already have some background and hopefully higher credit score it may be well worth it consolidating your student debt.
There are 2 ways to do that.
1. Federal Student Loan Consolidation
You can use this type of debt consolidation only to consolidate federal student loans.
It is also called a Direct Consolidation Loan. In essence, you get a new federal loan to consolidate your current federal student loans.
Unfortunately, the Direct Consolidation Loan can’t save you money on interest. According to official information by the Federal Student Aid, The interest is calculated in the following way:
“The fixed-rate is the weighted average of the interest rates on the loans being consolidated, rounded up to the nearest one-eighth of one percent.”
That means your new interest rate can be even slightly higher than your average rate. A federal student loan consolidation can extend the time to repay your federal student debt(up to 30 years).
So your montly installment can decrease drastically. However, because you don’t save on interest and you extend the repayment period, you can end up paying much more in total than you were supposed to pay originally.
On the bright side, it simplifies your payment by combining all federal student loans in a single one. Also, there isn’t an application fee.
Most importantly by consolidating your federal student loan you can become eligible for certain federal loan protections, forgiveness programs, and income-driven repayment plans. You can learn more about federal student debt consolidation and its benefits here.
2. Private Student Loan Consolidation
This type of loan consolidation is the normal debt consolidation service provided by private lenders. With it, you can consolidate both federal and non-federal loans.
Of course, you lose the federal protections, repayment plans, and forgiveness option federal loans and federal debt consolidations are offering. However, you will be able to save on interest. Also, you can consolidate more loans into a single payment, not only student loans.
Healthcare is one of the greatest expenses in the budget of the average American. The first step to avoiding high medical bills is having adequate medical insurance.
This is important not only for your physical but for your financial health as well. When you have medical insurance you can negotiate the overall cost of your medical bill. People who have medical insurance should pay less than the ones who don’t so stand your ground.
Sadly, there are some instances where medical insurance won’t be enough to cover your medical bills. For example, in the case of an unexpected accident or emergency.
That is another reason to carefully examine your medical insurance terms and coverage.
Generally, medical bills have low or no interest rates. Also, you can ask your healthcare provider to make you a payment plan if you can’t afford to settle your medical bills with a single payment.
However, if you made the mistake to pay your bills with high-interest credit cards you may find yourself swamped in medical debt. Then it is a good idea to do a loan consolidation as fast as possible.
Credit Card Loans
That is one of the most common reasons for debt consolidation. Credit cards typically have huge interest rates. However, that is not the case for all credit cards.
Many providers offer 0% introductory interest rate credit cards. The 0% rate is usually for a set period of time between 6 and 18 months. If you qualify for this type of credit card the best way to consolidate your credit card debt could be with a balance transfer.
By transferring your high-interest balance to a new, 0% interest or lower interest credit card you can save tons of money. However, you should be very mindful when doing that.
Your cleared credit card balances may trick you into spending more and returning to old harmful spending habits. Don’t be tempted and make sure you budget your spendings.
If you are not eligible you can explore some other ways to consolidate your debt that we are going to discuss next.
What Are Some Ways to Consolidate Your Debt?
There isn’t a universal approach to consolidate your debt. There are many ways to do that.
We already mentioned balance transfer as a form of loan consolidation. If you can get a 0% initial interest rate credit card that can be a perfect way to consolidate smaller amounts of debt.
Ensure you will be able to pay your outstanding balance before the high-interest rate kicks in. Here are other popular ways to consolidate debt.
Unsecured Personal Loan To Consolidate Debt
Another common way to do a debt consolidation is to get an unsecured personal loan. This can be a great way to consolidate debt into a single fixed-rate payment with a lower interest rate compared to credit cards.
Moreover, you can typically borrow more money with a personal loan. Thus you can consolidate more debt, like student debt, medical debt, and credit card debt.
Secured Personal Loan To Consolidate Debt
You can also get a secured loan against collateral to perform a debt consolidation. In most cases, the collateral is your house your car, or another high-value asset you possess.
The advantage of this type of debt consolidation loan is that you can get much lower interest rates. However, if you fail to make the payments you can lose your collateral so think carefully before you take this risk.
Can Banks Help With Debt Consolidation?
You may ask are there any banks that help with debt consolidation? Actually, all banks offer some sort of debt consolidation. Most offer balance transfers and secured loans but some do offer unsecured loans as well.
Despite that, banks usually demand an excellent credit score to provide you with a loan and a competitive rate. Most people find online lenders a better alternative to get a debt consolidation loan than banks.
For example, with guidetolenders, you can compare multiple lenders and choose the offer that suits you best. You don’t have to spend hours in a queue and fill in a huge pile of documents.
The process is simple, it takes around 5 minutes and you can get your funds in as little 24 hours. It’s obvious why most people prefer this to banks.
Debt Management Program
Nevertheless, many people get stressed out and seek external help with debt consolidation. Probably you have heard of bank debt management before.
There are companies that offer debt management services and debt counseling. Most of these companies are non-profit counseling agencies. They can negotiate a better interest rate and repayment terms with your lenders on your behalf given the fact, you repay the loan in 3-5 years.
Those debt management programs typically come from banks or credit unions and they are not a loan. However, your best bet is to apply through a non-profit credit counseling agency, preferably certified by the NFCC.
If you are approved for a debt management program you simply make one monthly payment towards the debt management counseling agency. Then the credit counseling agency uses that amount and distributes it to each of your current lenders.
An important note is that debt management programs don’t guarantee that the amount you owe as a whole will reduce. On the other hand, private debt settlement companies promise they will reduce your current loan amount.
It is extremely important to distinguish between debt management and debt settlement. Debt settlement offered by private companies is typically dangerous.
It can be detrimental to your credit score and attract a lawsuit from your lenders. All of that without even achieving the desired result to reduce your debt.
We would generally recommend staying away from debt settlement. Unlesss your credit account is long past due or already in collections it wouldn’t make any sense seeking debt settlement companies.
The best way to consolidate debt depends on your personal financial situation and preferences.
You can do regular debt consolidation and refinance your existing loans with a new loan. Or you can seek the help of a debt management company.
Still not sure whether debt consolidation is a good idea for you? Don’t make an uninformed decision. You can always read more. For example, you can take a look at our guide on when it makes sense to get a personal loan.
However, the power to solve your debt issues lies within you. Don’t procrastinate. No matter if the issue is big or small. Act today so you are one step closer to living debt-free tomorrow.