How Does Debt Consolidation Work?

Sometimes, it’s easy to get overwhelmed with trying to keep track of all your debts and remembering to pay them up at their different due dates. In such situations, many people resort to consolidating their debts to manage the payment process more easily. 

How does debt consolidation work, and should you consider it? Debt consolidation is one of the many ways to cope with your debt; it helps simplify your payment process and makes it easier to handle.

If you have been neck-deep in debt, you’ll easily relate to the frustration of having to deal with multiple creditors, unpleasant phone calls, and reminders. In this article, we’ll tell you everything you need to know about debt consolidation, how it works, how it affects credit scores, the pros and cons, so you can judge for yourself whether this is the best solution for you.

What Is Debt Consolidation?

Debt consolidation is the process of taking out a new loan to settle your existing debts, such as bills, overdrafts, credit card balances, student and auto loans. This way, rather than dealing with the payments of these individual debts, you only get to focus on making one monthly payment because all your loans have been combined into a single debt to just one creditor.

Many financial institutions offer these loans with a fixed interest rate. Some may require collateral; others don’t.

Debt Consolidation vs. Debt Settlement

Debt consolidation is often mistaken for debt settlement, and most times, you hear people use them interchangeably. As much as they may sound similar, debt consolidation’s meaning differs greatly from that of debt settlement.

Debt settlement involves hiring a reliable debt settlement service to help renegotiate your previous loans to a smaller amount. In contrast, debt consolidation requires you to pay your full loan but reduces the number of your creditors by transferring all your debts to a single lender. Basically, debt settlement aims to reduce your debts, while debt consolidation seeks to reduce the number of your creditors.

Presented this way, debt settlement might sound like the better option of the two - mainly because you get to pay up to 70% less than initially owed. However, you need to know that lenders are highly unlikely to forgive even a slight portion of your debt unless they judge your financial situation to be dire.

How Does Debt Consolidation Work?

While debt consolidation is simply described as combining your debts into one big loan, technically, this is not possible. What actually happens is that you take a bigger loan so that you can pay off your other loans and settle your creditors; that way, the only loan you need to focus on repaying is the one you took to clear the other debts. This helps when you have high-interest loans that require you to pay for a long period; with this bigger loan, you can quickly pay off those loans without having to worry about accruing higher interest.

Perhaps, at this point, you might wonder, “How does debt consolidation help if it effectively entails accruing more debt?” Let’s look at an example. 

Eric has the following debts:

1. Student loan of $1,000 with 10% APR
2. Bills worth $500
3. Auto loan of $1,500 with 15% APR
4. Overdraft worth $750

That’s a total of $3,750 with four due dates and payment plans. Eric can consolidate these debts by taking a $3,750 loan with a 5% APR to clear his existing debts. The financial institution can either pay his creditors directly or send the money to him to make the payments.

Not only does debt consolidation make it easier to track debts, but it also saves you the cost of paying higher interest rates over time.

Types Of Debt Consolidation

Now that we’ve answered the question “How does debt consolidation work?” it’s time to look at the different types of debt consolidation.

Debt Consolidation Loan

A debt consolidation loan is a personal loan you take out to consolidate your debts, lower the interest rates, and possibly improve the terms of your loan. We can divide this type of loan into two broad categories: secured loans and unsecured loans.

Secured loans need to be backed up by an asset as collateral, like a house or a car, while unsecured loans don’t require collateral, although they may come with a higher interest rate.

How does a debt consolidation loan work? It involves taking a loan from either a bank, credit union, other financial institutions, or moneylenders to pay for your existing debts. Most banks will offer you lower interest rates if you have a decent credit score and some good collateral. Other financial institutions or companies may not be as strict as the traditional banks, but they may have higher interest rates.

Payday Loan Debt Consolidation

This is another type of debt consolidation, quite similar to the debt consolidation loan. 

A payday loan is a short-term loan with high interest rates that people take out when they need immediate cash to make urgent payments. The amount you owe, plus the interest rate, used to be deducted from your next paycheck, hence the name. 

How does payday loan debt consolidation work? You take out a personal loan to consolidate your existing payday loans. This helps reduce the interest rates of your payday loans and extends the repayment time.

Student Loan Consolidation

Student loan consolidation is one of the debt solutions available to students. It helps them consolidate all or some of their student loans. With it, you can make single monthly payments and enjoy access to additional loan repayment plans and forgiveness programs.

However, this may cause losing certain borrower’s benefits, such as discounted interest rates or some loan cancellation benefits attached to your current loans.

Credit Card Balance Transfer

Credit card consolidation or balance transfer involves transferring all your credit card balances to a single card.

How does credit card debt consolidation work? Credit card companies offer balance transfer credit cards with attractive interest rates, sometimes even as low as 0% for a specified period, depending on the card you qualify for. If you get one of these cards, you could transfer the balances from your other cards at no cost and enjoy single monthly payments at a lower price. 

Note that failure to pay up your balance within the stipulated period attracts a higher interest rate; this may double your debt if you take longer to pay.

Home Equity Loan

This is a type of loan that is secured by the equity of your home. It often comes with a much lower interest rate since your home serves as collateral.

Debt Consolidation: Pros and Cons

Unless you inherit a fortune or win the lottery, there is no easy way out of debt. Besides the benefits, debt consolidation has its downsides too. Having an overall picture of what it entails can help you make informed decisions.

Pros

• It simplifies your debt management process.
• It reduces your interest rates/charges.
• The interest rate is fixed.
• Paying off your debts more quickly can improve your credit score.

Cons

• Some loans may require collateral.
• If you get a loan with a longer payment schedule, you may end up paying a higher interest rate over time.
• For student loans, you may end up losing out on other borrower’s benefits.
• Some debt consolidators may charge extra fees for their services.

What Is the Best Way To Consolidate Debt?

There is no one-size-fits-all answer to this question, as it depends on your situation and the type of debts you are looking to consolidate.

For instance, while the student loan consolidation may be the best plan for a student with several student loans, this may not be the best option if you want to clear off your payday loans.

Ultimately, before you choose the best debt consolidation option for you, you may need to consider certain factors, such as: 

• Your cash-flow
• The payment schedule and duration
• Whether or not it requires collateral
• Your credit score
• Interest rates
• Extra charges or fees

Debt Consolidation and Credit Score

How does debt consolidation affect your credit score? Debt consolidation can both reduce and improve your credit score. It could improve it if you manage to pay off your debts on time without delays. On the other hand, failure to meet the stipulated payment schedule gives the impression that you are not creditworthy, and this can be detrimental to your credit score.

It’s also important to mention that having a good credit score matters when you’re considering debt consolidation as it can qualify you for competitive loans with lower interest rates, while a debt consolidation with bad credit may mean that you get to pay higher interest rates.

Conclusion: Is Debt Consolidation A Good Idea?

In this article, we have carefully reviewed the meaning of debt consolidation, how it works, the various types, and the pros and cons, and we hope that you now have a clearer picture of what it entails.

Debt consolidation is beneficial to people looking for a way to organize and track their debt payments. However, if this is the main goal you’re looking to achieve by consolidating your debt, there are alternatives, such as debt management plans, you should look into.

If you’re still wondering, “Should I consolidate my debt?” carefully consider your monthly income, credit score, the available loans and their interest rates, fees, duration, and whether they require collateral or not.  It’s also advisable to research other available options and consult your financial advisor if possible. Don’t forget that, sometimes, you may end up paying more interest rates, which defeats the purpose of consolidating your debts.