If you have a fair amount of high-interest debts, you may have heard that debt consolidation is a good answer for you. However, you’d like to learn a bit more about how it works.
You want to know if it’s the right option for you. In this post, we’ll explain the ins and outs of debt consolidation.
What is Debt Consolidation?
First and foremost, it’s pretty simple. You apply for a loan that comes in at a lower interest rate and use it to pay off your debt. You end up paying one installment at a lower interest rate and usually with lower payments.
It’s a solid plan when it’s approached correctly, but it isn’t going to be right for everyone. The first thing to understand is that all you’re doing is shuffling the debt around. If you go out and max out those credit cards again, you’ll be in a much worse position than you are now.
So, before you take this route, you need to look at why you’re doing it. Are you considering it because you want to be able to save interest? Or is it because you’re drowning in debt and need a lifeline?
Most Common Reasons for Debt Consolidation
If it’s the latter, don’t feel too bad. All of us make lousy credit decisions at times. The reason that debt consolidation is so popular is that so many of us make credit mistakes.
The most common reasons for debt consolidation include:
- Paying off high-interest credit cards: To be fair, it’s a pretty good strategy as long as you close off those credit card accounts. You’ll also have to pay at least the same monthly payment to the load that you would have paid to the card
- Paying off student loans: If you can get a loan at a better interest rate, it makes sense to consolidate your student loans. You’re not alone here either. Millions of Americans struggle with paying off their student debt
- Repairing Credit: Debt consolidation means that all those previous debts are now paid off. This can help you do a quick credit repair while increasing your debt to available credit ratio.
When is it a Good Idea?
How do you know if debt consolidation is the right strategy for you?
For it to successfully save you money, the following should be in place:
- Your debt is no more than 50% of what’s coming in
- You’ve got great credit and qualify for a low rate or zero-interest credit card
- Your financial situation and credit rating have improved significantly since you took out the debt
- You can continue paying the new debt at the same pace you would have with the old debt
- You have a solid plan to stop you from running into debt again
Let’s look at a situation where debt consolidation would make good sense for you. You have three credit cards with rates between 16% and 24%. You can get a loan to consolidate them at 7%. That’s a no-brainer. You’d want the better interest rate.
There are also instances when it makes sense to consolidate, even if the interest difference is not that much. Say, for example, that you’re battling to pay off your debt right now and are concerned that you’ll have issues in the future.
You could consolidate your debt and ease the repayment terms that way. If it’s the difference between having your home repossessed or defaulting on your credit agreements, it could make sense for you.
This should be viewed as a one-time deal, however. Get yourself out of hot water financially, once possible, and don’t run up new debt after this.
This plan can make sense if it means avoiding legal fees and late penalties, but only if you’re not going to run up your debt later.
If you find that you’re having a hard time managing your spending, switching your debt from a revolving limit to a personal loan payment plan might also make sense. That way, you know that after the term has expired, your debt is repaid.
When is it a Bad Idea?
Throwing in more credit is not always the best idea. If you’re bad at controlling your spending, consolidating is not going to solve that issue. You need to address why you spend in the first place.
Picture this, you consolidate your debt and promise yourself it’s the last time. Then your car breaks down, or you have medical bills to pay, so you use your credit cards again. Maybe you decide that you need a reward for doing so well with your spending, so you buy something else on credit.
Whatever the reason for it, you end up running up your old credit cards, and you’re back in the same boat again. That’s when consolidation is a particularly bad idea.
It’s also not the best solution if you’d battle to pay down the new installment. All that would happen is that you’d consolidate the debt, and then start taking new loans to make up the shortfall. If your debt is out of hand, it’s better to speak to the companies concerned and negotiate an arrangement.
Over the long term, it may seem like more work, but at least you’ll be able to pull yourself out of the debt spiral. If debt consolidation is a last-ditch attempt to stave off your creditors, you’d be better off trying debt counseling.
This way, you would have one less creditor to deal with when you can’t make payments.
Another area where it doesn’t make sense to consolidate is when you have a little debt that will be paid off in six months or so. The costs of initiating the new loan are not likely to outweigh the benefits that you’ll receive from the lower interest rate.
What you could then do instead is to go the DIY route by using one of the following two methods to squash your debt.
The Snowball Method
With this method, you target the debt with the smallest balance.
You pay the minimum on all other debt and pay as much as possible extra on the others. When that balance is paid off, you apply the installment you were paying there into the next lowest balance on the list.
In terms of getting the best deal financially, the debt snowball method is not as good as targeting the highest-interest debt first. Over time, you’ll pay more interest here than you would with the Avalanche method.
The reason to choose this method, though, is that it gives you an easy win. It’s a lot easier to pay off a balance of $200 than $2 000. This little win can help keep you motivated and help you stick to your plan.
The Avalanche Method
With this method, you find out which account has you paying the highest rate of interest.
You pay the minimum on all the other accounts and put any extra money toward paying off the highest interest accounts. When that’s paid in full, apply the payments to the next on the list.
This approach does make better sense financially, but you won’t get the psychological boost of paying off a series of small debts very quickly.
Before you rush into debt consolidation, it’s essential to examine the reasons why you are in debt in the first place. The truth is that most people are going to go this route to ease their financial burden.
It can work as long as you deal with the issues that landed you in a mess to begin with. Consider the situation carefully and be realistic about your circumstances. If you can do this, you might be able to make consolidation work for you.