Debt can be difficult for anyone to tackle. It can be especially difficult for households with limited incomes and resources.
Residents who do not have a lot of experience with budgeting, do not know how to do so effectively or are simply make too little to budget can feel even more overwhelmed. However, there are several ways for those struggling with debt to turn their financial situation around.
One way that residents can find relief is debt consolidation. This can be an effective method especially for those who have undergone credit counseling and reviewed all of their other options. A benefit to this method of debt management is the reduction in monthly payments. However, there are some drawbacks to this solution as well. Continue reading the sections below to determine if debt consolidation is the right decision for you.
Defining Debt Consolidation
The process of debt consolidation involves a resident who is in debt purchasing a new loan to pay off most, or all, if his or her debts. This method allows debtors to combine multiple debts and loans into one large loan. By doing this, residents can obtain better repayment terms including a lower interest rate and monthly payments. However, it is important for debtors attracted to this option to be aware of the drawbacks.
Debtors who frequently only pay the minimum on their monthly loan payments will likely pay more over the life of the loan due to the increased repayment period. Although they are required to pay less each month, interest still adds up.
Moreover, certain debt consolidation companies may offer secure loans to customers. This means that debtors must provide certain assets as collateral such as their house or car in order to receive a loan. Residents who do not repay their loan will have these assets repossessed.
Debt Consolidation Types
Typically, consolidated loans are offered with reduced monthly payments, interest rates or both. Applicants with good credit may be able to obtain a personal loan or unsecured loan. These can come with set payments and conditions over a pre-determined amount of time.
There are two types of debt consolidation loans. One type is a secured loan, the other is unsecured. A secured loan is backed by collateral in the form of assets while unsecured loans do not require such collateral but may have higher interest rates. While both loans can be difficult to obtain, both typically have lower fixed rates than most credit cards.
There are several options for those who want to get a secured or unsecured loan. The following are some common options:
- Credit card balance transfer— Under this method, debtors combine multiple loans under and card balances onto one card that has a low interest rate. Applicants with credit may be able to achieve a balance transfer at low or no cost.
- Home equity loan— This is known as a second mortgage or home-equity loan installment. This method utilizes the equity of a home as collateral. Many residents who own a home can qualify for this type of loan. However, failure to make payments on this loan can result in foreclosure.
- Consolidating student loans—There are a few options for residents struggling with student loan debt. The federal government allows debtors to consolidate these loans at no cost. Other student loan lenders may offer refinancing options and private lenders may permit consolidation as well but for a fee.
When Debt Consolidation Might be the Right Decision
Consolidating debt is a good option for some residents but not for others. Some financial circumstances make debt consolidation the best option. Residents who have multiple debts that total more than $10,000 with high interest rates or have difficulty making monthly payments can benefit the most from debt consolidation.
However, residents who have smaller amount of debts or who are not confident that they can pay off their debts within five years may not be ideal candidates for debt consolidation. To successfully consolidate debt, residents’ debts must meet the following requirements:
- The debtor is able to make consistent and timely payments.
- A resident’s total debt is no more than 50 percent of his or her annual income.
- The debtor is eligible for a low or no-interest consolidation loan or credit card.
Disadvantages of Debt Consolidation
Residents should carefully evaluate their options before moving forward with debt consolidation as there are several risks and drawbacks to the process. Any loans comes with risks and it is important to be aware of them in order to make an informed decision. Different loans have different terms and conditions. Understanding the components of different loans can help residents with debt select the loan option that they can best follow. The following are common risks of loans that debtors should be aware of:
- Damage to credit score – At first, a debt consolidation loan can cause damage to a resident’s credit scores. However, making consistent payments on the loan can increase the credit score over time. Although, debtors who miss a payment will likely see an additional decrease in their credit scores.
- Lengthy loan terms – The length of debt consolidation loan is usually much longer than the original loans. Thus, consolidated loans take longer to pay off.
- Potential to lose assets – When debtors have to sign up for a secured loan, they risk losing certain assets if they fail to make payments. For instance, residents may have to use their home as collateral. They risk foreclosure if they can no longer make payments on their loan. While debtors can also seek an unsecured loan, they will find that it is more difficult to find.
- No special terms – Loans such as student loans have certain special terms or benefits. For instance, students are often permitted to defer payments while enrolled in school or during a time of financial hardship. However, a consolidated loan that include these schools loans will remove these benefits.