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What Is Debt Consolidation?

How to consolidate your debt

If you’re trying to figure out how to consolidate debt, the process is fairly similar no matter which form of debt consolidation you are using. It’s important to understand that debt consolidation is different from debt settlement. With debt consolidation, you will use the funds from your new debt consolidation loan to pay off all of your existing debts in full.

Once you’ve gotten the funds from your personal loan, home equity line of credit or other debt

consolidation loan, you can start the debt consolidation process. Use those funds to pay off all of your existing debts. Then you will have only one monthly loan payment, generally with a lower interest rate than all of the interest rates on your previous loans.

Debt consolidation pros and cons

Debt consolidation isn’t the right choice for everyone; before consolidating your debt, consider the pros and cons.

Pros

  • Credit score improvement. You could see a credit score boost if you consolidate your debt. Paying off credit cards with a debt consolidation could lower your credit utilization ratio, and your payment history could improve if a debt consolidation loan helps you make more on-time payments.
  • Less total interest. If you can consolidate multiple debts with double-digit interest rates into a single loan with an interest rate below 10 percent, you could save hundreds of dollars on your loan.
  • Simpler debt repayment process. It can be hard to keep track of multiple credit cards or loan payments each month, especially if they’re due on different dates. Taking out one debt consolidation loan makes it easier to plan your month and stay on top of payments.

Cons

  • Collateral at risk. If you use any type of secured loan to secure your debt, such as a home equity loan or HELOC, that collateral is subject to seizure should you fall behind on payments.
  • Higher possible cost of debt. Your potential for savings with a debt consolidation loan depends largely on how your loan is structured. If you have a similar interest rate but choose a longer repayment timeline, for instance, you will ultimately pay more in interest over time.
  • Upfront costs. Any form of debt consolidation could come with fees, including origination fees, balance transfer fees or closing costs. You’ll want to weigh these fees with any potential savings before applying.

How to decide if debt consolidation is right for you

Debt consolidation makes the most sense if your spending is under control and your credit score is high enough to qualify for a more competitive interest rate than you’re currently paying. You should also consider your current debt load when deciding if debt consolidation is right for you. If it’s manageable, doesn’t take up an excessive amount of your monthly gross income, and will take more than a few months to pay off, consolidating your debt could be a smart financial move.

When not to consolidate debt

Debt consolidation is only effective if you’re disciplined enough to stop using the credit cards you pay off. Otherwise, you risk accumulating far more debt than you started with. It’s equally important to ensure you can afford the amount of the monthly payment on the debt consolidation loan. If the payment stretches your budget too thin, you could fall behind rather quickly and damage your credit rating.

Also, consider your credit rating before you decide to consolidate debt. If your credit score is on the lower end, the lender or creditor will likely only offer steeper interest rates to help you consolidate what you owe.

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Bottom line

If you’re interested in debt consolidation, make sure that you have considered the underlying reasons for how you got into debt in the first place. If you’re in a more stable place but have debt from earlier in your life, then debt consolidation can make a lot of sense. Take the time to examine all of your options and get quotes from several lenders, including credit unions, online banks and other lenders. Compare interest rates, fees and terms before finalizing your decision.

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