How to consolidate debt
What is debt consolidation?
Debt consolidation is when a person obtains a new loan to pay out a number of smaller loans. The end goal is to have all of the various debts 'consolidated' under one combined loan and to have one payment where once there were many.
Why consolidate debt?
Some of the main reasons a person might want to consolidate their debt are:
- Simplification. Having a number of different products with varying interest rates and payment terms through different financial institutions can be difficult to keep track of and cause unnecessary stress and frustration.
- It has the potential to save the borrower money by reducing the interest rate if they're able to secure a lower rate then what they're currently paying.
- Debt consolidation can also result in a smaller monthly payment, depending on the interest rate and amortizations period.
- To get out of debt faster. Some who are able to secure a lower interest rate still opt to keep their existing monthly debt payment the same. This enables them to pay down their debt (the principle) faster than they otherwise would have.
Different ways to consolidate debt
- Debt Consolidation Loan: if you have a decent credit score and have collateral (security for the loan) to offer, this could be an option. It usually has fixed repayment terms.
- Home Equity Loan: this option usually offers the lowest interest rate and can be a great option for those who have a decent amount of equity in their home.
- Line of Credit: Another low -interest option for debt consolidation. Lines of credit can be secured by your home or your financial institution may offer you an unsecured one if you have good credit and a stable income. The downside of consolidating this way is that you have to discipline yourself to pay a set amount each month that is much higher than your minimum monthly payment. If you only pay the minimum, it will take decades to pay off.
- Credit Card Balance Transfer: credit cards often offer low interest rate balance transfers as a means of debt consolidation. While this can be very attractive, it can end up being a bit risky. If you don’t pay off your balance by the end of the low interest promotional period, you usually end up paying normal credit card interest rates of around 20%. This will double your debt if you take 7 years to pay it off.
What are the risks?
If used as intended, debt consolidation can be a useful tool in helping a person get their finances back on track.
However, oftentimes those who consolidate debt end up right back where they started because they fail to address the underlying issues or financial habits that had them struggling with debt in the first place. They can even end up with more debt than they started with.
When you receive a loan to consolidate your debt, most of your other borrowing products remain active. Your credit cards aren't automatically cancelled. This means that a person could potentially incur new charges on those cards, or even max them out. If you do this before paying off the debt consolidation loan, you're going to end up with more debt and more payments, instead of less.
In order to ensure you don't end up in this situation it's important that you learn to BUDGET (link to budget article). Having an 'accountability buddy' who you trust to maintain your confidence can also be a handy way to make sure you don't backslide into old habits.
Do you need some help getting started, or want some advice on which solution might be best for you?