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Debt consolidation is an effective – and at times, necessary – financial and debt restructuring strategy for those who have accumulated debt from multiple sources and are looking to streamline payments and costs.
It involves combining multiple debt into a single loan or payment plan with the goal of reducing the number of creditors, simplifying debt management, reducing interest rates and payments.
it is critical to understand how debt consolidation works, whom it is useful to, and its advantages and disadvantages before deciding if this is the right approach for you.
Debt consolidation utilizes multiple different methods to unify someone’s outstanding debt into one singular loan, ideally to simplify payments and lower interest rates.
These often involve either taking out a loan or credit card to pay off existing loans or finding a lender who is willing to buyout other creditors and who will agree with the borrower on a payment plan and interest rate.
These loans can be secured – as in with an asset such as a house – or unsecured loans. The latter, however, may come at a higher interest rate.
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These are personal loans obtained from a bank, credit union, online microfinancing platform or other lender to pay off all outstanding debt. The borrower then makes one singular payment.
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This method involves transferring the multiple balances of credit cards into a new card that offers lower or next to 0% interest for specific duration – usually, as a promotional tool. Paying off the balance within that duration is crucial to not incur higher interest rates.
Those that have accrued equity on their home or property can be eligible for a home equity loan as an option to consolidate their debt. These secured loans use your ownership in the house as collateral for the loans and usually offer interest rates higher than the monthly mortgage rate but are generally lower than credit card rates or some other personal loans because of the collateral.
Some government agencies or NGOs offer debt restructuring and management financing programs as a public service, with state-owned banks offering secured loans or providing guarantees to support debt refinancing, which could include debt consolidation.
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Benefits of debt consolidation include:
i) Simplified payments: By consolidating all outstanding debt into one, the borrower has only a single recipient, facilitating payments and reducing the risk of missing payments.
ii) Fixed repayment schedule: Debt consolidation often comes with a fixed payment schedule and timeline so all dues are accounted for in advance.
iii) Potential for lower rates: in an ideal scenario for the borrower, the interest rate on the consolidated debt would be lower than total interest payments on the various loans and credit card.
v) Potential for improved credit score: If consolidating debt payment helps reduce the debt burden on the borrower and leads to successful repayment, it can help improve their credit score in the long term.
Some of the downsides of debt consolidation include:
i) Upfront costs: Consolidating debt can include fees such as transferring fees or loan origination fees or closing cost on a home equity loan.
ii) Risk of accruing more debt: Failure to meet the payments of a consolidated loan may risk further debt, as well as potentially restructuring loans at a higher interest.
iii) Collateral risk: In the case of secure loans such as home equity loans, failure to make payments can lead to the foreclosure and repossession of the asset.
v) Short term credit score hit: Credit scores generally favor long-term loans that show consistent payment. Closing long term debt and opening a new one could have a short-term hit on one’s credit rating.
Debt consolidation can be a beneficial tool for those who are struggling to manage their debt and payments. it typically works for those who have substantial unsecured debt, such as large credit card debt.
To be able to qualify, a borrower must have steady monthly income and a high credit score – the latter will be crucial to secure a lower interest rate on debt consolidation.
The ability to make regular payments will be crucial. This involves financial discipline and budgeting. The alternative could see the borrower fall deeper into debt and hurt their access to further liquidity.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
