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How Does Debt Consolidation Work? Get Debt Free in 2022

When you want monetary help with debt, it’s easy to feel like you’re in a boat with a hole in it. As fast as you try to shovel money out to one creditor, another one dumps interest or fees into your balance and you owe as much or more. Before you jump into a debt consolidation loan, take a moment to do a little research.

First, these US debt statistics will help you see you aren’t alone.

  • The average US household has about $155,000 worth of debt, including their mortgage.
  • 35% of Americans felt their household financial situation worsened during the past year.
  • Many people – 18% of Americans – relied on credit card debt to get through the pandemic.

It is unnecessary for you to get caught in debt. Debt consolidation helps ease stress of multiple payments and due dates through low-interest loans. Money helps you repay your debts, allowing you to pay one monthly payment.

What Is Debt Consolidation?

Debt consolidation is a way of dealing with debt that involves taking out a new loan in order to repay all the other loans and debts. The new loan could be from a few different sources. The best choice may depend on what is available to you and the nature of your debts.

How Does Debt Consolidation Work?

Debt consolidation works by changing multiple monthly payments into a single payment. This happens by taking on new debt, repaying all your old debt, and then working to repay the new creditor. There are a few different ways to do this and we’ll show you the best ones in just a moment.

What Are the Types of Debt Consolidation Loans?

If you’re struggling with your debt, or just trying to get ahead financially, then there may be four types of loans available to you. Each one has some pros and cons, so it’s worth taking the time to evaluate them to decide which one is most suitable for your situation.

Debt Consolidation Loan

A debt consolidation loan is an unsecured personal loan provided by a bank or financial services provider. It will help you consolidate debt payments into a single payment. Personal loans may have higher interest rates because there is no collateral for the loan. However, having just one monthly payment may make everything more affordable and help you get out of debt faster.

Credit Card Balance Transfer

If you are carrying multiple credit card balances, then combining them into a single new balance could be a great solution. This is especially true if you are only making minimum payments on multiple debts every month. Making only the minimum payment means your credit card debt will remain for a long, long time. By transferring the debt to a new balance transfer card, you can combine monthly debt payments into a lower payment. This should give you space to pay a little extra every month and start getting ahead.

Home Equity Line of Credit (HELOC)

If you own a home or have a mortgage with equity, then a home equity loan might be the best choice. Since you are offering your house as collateral, you should have a lower interest rate than most debt consolidation loans. However, you may also be paying the outstanding debts off over a longer period of time, which could be more expensive. Home equity loans that extend payments over more than 10 years are likely to mean you end up paying more.

Student Loan Consolidation

If you have multiple student loans, then you could consolidate them into a single loan. Consolidating debt this way could give you a single monthly payment and help you manage your loans. There are two ways to do this:

  • Consolidate debt through the Department of Education. They will repay your existing loans and create a single new loan. This may be a good way to simplify your payments and qualify for federal debt repayment programs, but you will not get a lower interest rate and it may be harder to save money with this strategy.
  • Take out a student debt consolidation loan with a personal loan provider. You could combine your outstanding debt with a low interest personal loan, but you’ll need fair credit to make this work.

Before you choose your strategy, let’s talk about how to make a debt consolidation loan work for you.

How a Debt Consolidation Strategy Could Help You

Reduce Your Monthly Payments

A debt consolidation loan will not automatically reduce your monthly payments, but it could do so. You can make a list of your debts, their monthly payments, monthly payment minimums, and then total the monthly payments and monthly payment minimums. Then you can compare this to what you would get with a secured loan or unsecured loan. With this information, you will know if debt consolidation offers you lower monthly payments or not.

Change High interest Debt to a Lower Interest Rate

If your debt includes unsecured debts with high interest rates, then changing to a lower interest rate could save a lot of money. For example, if you have a $5,000 credit card balance at 18.9% interest and you convert this to a 12% interest rate, then you could save $1,500 and pay off your debt 24 months faster, even making only the minimum payment.

Could Improve Your Credit Score

If you have multiple lenders with missed payments or a high debt to income ratio, then a debt consolidation loan could improve your credit score by making these go away. You could reduce the number of debt accounts that are maxed out (which is bad for your credit score) and focus on making on-time payments each month, which will help improve your credit score.

Simplifies your Bill Paying with a Single Monthly Payment

One challenge of being in debt is keeping up with multiple monthly payments. This can be an even bigger problem if you have credit card debt that penalizes you for missing monthly payments. A debt consolidation loan gives you just one monthly payment to make each month, making life a little simpler.

Now it’s time to consider the alternative. Should you consolidate your debt?

Should I Consolidate My Debt?

You don’t have to take out a debt consolidation loan. Personal loans are just more debt, and they may not help you fix the underlying problems that got you into difficulty. Let’s dig into a few reasons why you might choose another route instead of going through debt consolidation.

There’s No Point to a Debt Consolidation Loan without a Lower Interest Rate

Let’s be really clear about two things:

  • If you do not lower your interest rate, then a new personal loan will not save you money. Combining multiple credit cards into a single payment with lower interest is smart, though.
  • If you do not increase your repayment rate, then you will not save money. Combining multiple debts into a single debt that you pay off faster is also smart.

So, if you are going to consolidate debt, then look for loan funds with a smaller interest rate so you have less interest payments to make, which will save you money.

Check the Balance Transfer Fees and Interest Rate

New credit accounts may have an introductory interest rate that is lower than your current rates. However, this could change after 6 months or 12 months. If you haven’t repaid the balance by then, you could end up with a worse rate than before.

Consolidating Debt Means Being in Debt Longer

If you consolidate your debt without lowering your interest rate or changing your monthly payment amount, then you will simply be in debt for longer and pay more money. 

There’s a Difference Between Consolidation and Elimination

Debt consolidation doesn’t actually remove any of your debt. It may help with the monthly bill and pay off a few credit cards, but you will still owe the full amount. Without a plan to repay the debt, you will still owe all the money. All you will accomplish is moving your debt balances around to new companies.

What Are Alternatives to Debt Consolidation?

There are at least two solid alternatives to debt consolidation loans. Each has some advantages and disadvantages, so consider them carefully.

Debt Settlement Could Reduce Your Balances

Debt settlement is when you negotiate a lower balance due on your debts. This is usually done when you are already late or in default. You agree on a final balance with your creditor, close the account, and then make payments or pay off the entire balance.

However, there are some problems:

  • The process almost always involves missing monthly installments and this will destroy your credit score.
  • You have no guarantee of success because your creditors could refuse to negotiate or even sue you for the remaining balance.
  • There may be fees you don’t know about, such as taxes on forgiven debt or fees charged by any debt settlement company.

Filing for Bankruptcy

If you’re overwhelmed by debt and don’t feel you have the means to pay back consolidated debt, you may want to consider bankruptcy. Deciding the best route for you can be a difficult decision to make, so we recommend consulting with a bankruptcy attorney so you understand all your options. Contact our bankruptcy lawyers in Florida today at (954) 922-2283 or fill out the form below.

Written By:

Attorney Robert Stiberman

Robert is an experienced bankruptcy attorney adept at handling Chapter 7, 13, and 11 filings, with more than 15 years of experience in bankruptcy cases. Robert represents clients in both consumer and business bankruptcy ... Read More

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