Finding yourself overwhelmed trying to stay ahead on multiple credit card and loan payments month after month? If keeping track of mounting interest fees and due dates feels like a losing battle, debt consolidation may offer a constructive solution.
What is debt consolidation? Consolidating debts combines all your separate repayments into one new consolidated loan and single monthly payment. At first glance, this approach can seem an efficient path to organize finances and potentially even save on interest. However, debt consolidation also comes with serious risks like extended repayment periods, collateral damage from defaults, or increased debt burdens if misused.
The key value proposition of debt consolidation loans is simplifying debt repayment for borrowers shouldering multiple loans and credit cards. Combining balances into a single, lower payment promises one straightforward path to becoming debt-free. However, it is critical to fully understand debt consolidation’s pros and cons prior to approval.
How Do Debt Consolidation Loans Work?
Debt consolidation loans function by paying off existing debts and then requiring regular payments toward the new consolidated loan until it is fully repaid. It is different from refinancing a loan which involves taking out a new loan with better terms to pay off an existing loan with typically higher rates.
Borrowers take out a large enough consolidation loan to cover the total of all current debt balances which can include credit cards, personal loans, medical bills, and other unsecured obligations. The proceeds from the new loan are then used to close the separate accounts and establish just a single loan with one interest rate, monthly payment, and payoff timeline.
The goal of consolidation is twofold: first, to lower monthly payment burdens by extending repayment terms over more years; second, to reduce the interest costs on debts when the consolidation loan offers a lower rate than prior ones.
Having a single payment each month instead of tracking multiple dates and variable amounts allows borrowers to budget repayment more easily as well. Now that you know what debt consolidation is and how it works let’s look at different types of debt consolidation loans.
Types of Debt Consolidation Loans
Debt consolidation loans come primarily in two forms: secured loans typically issued by banks, and unsecured personal loans usually offered by online lenders.
Secured Debt Consolidation Loans
Secured bank loans use collateral like homes or autos to guarantee repayment of the debt, allowing them to offer better rates since the risk to lenders is lower.
Common options include:
- Home Equity Loans – Uses available equity in the home as collateral
- Home Equity Line of Credit (HELOC) – Credit line against home equity
- Auto Equity Loans – Consolidation of debts using car title as collateral
While rates on secured consolidation loans are very attractive, defaulting risks surrender of the homes or vehicles collateralizing the loans.
Unsecured Debt Consolidation Loans
Unsecured personal loans do not require borrowers to post collateral to obtain them, so approval depends solely on the applicant’s creditworthiness. Interest rates are higher to account for the increased default risk lenders assume. Leading online lenders offer unsecured consolidation loan options with simplified applications, rapid decisions, and funding.
When Is Debt Consolidation a Good Idea?
The below situations indicate when pursuing consolidation of debts into a new loan can be prudent:
Interest Rate Reduction on Debts
If your current average interest rate paid across multiple debts exceeds 10-15%, consolidation loans can lead to substantial savings by cutting rate burdens significantly through refinancing at lower levels. Run the numbers to see if monthly savings from lower rates outweigh loan origination fees.
Payment Relief Needed
Consolidation benefits cash-strapped borrowers feeling overwhelmed trying to pay numerous debt payments monthly. Extending the repayment timeline through consolidation reduces monthly outflows allowing breathing room to better manage finances.
Prevent Debt Default
If facing potential default on debts, consolidation can ward off ruined credit ratings and harsh collector calls by restructuring debts into more affordable single payments as an alternative to delinquency.
Risk Factors of Consolidation Of Debts
While consolidating debt appeals to many facing unmanageable repayments, the strategy does present cons to consider seriously as well:
- No Reduction of Principal Owed – A consolidation loan pays off debt balances but those sums plus consolidation loan fees still must be repaid over the loan’s duration. No debt principal is eliminated, just restructured.
- Lengthier Repayment Period – Extending the payment period to lower monthly costs means paying more interest over the life of the loan. Avoid terms exceeding 5 years.
- Accumulating More Debt – There is a risk of ramping up debt levels again through continued reliance on credit cards without adequate budgeting adjustments to spending habits.
- Collateral Risks – Defaulting on home equity and auto title consolidation loans can lead to surrendering homes or vehicles used as collateral.
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FAQs
What types of liabilities can be integrated into a consolidation loan?
There is a wide range of loans that can be consolidated – including credit card balances, medical bills, personal debts, or payday loans. Federal education debt cannot be consolidated alongside other liabilities via this method.
How does one proceed with a consolidation loan application and acceptance decision?
Applications require the submission of financial credentials like income status, total debts owed currently, credit history, and any collateralized assets used to secure the requested loan amount. Lenders generally decide on consolidation loan approvals within a 1-2 week timeframe – borrowers can then finalize terms and complete account payoffs if suitable offers are extended.
Is it easy to qualify for debt consolidation loans?
Qualification criteria for debt consolidation loans primarily weigh factors like credit scores, debt-to-income ratios, employment history, and collateral assets. Having credit scores above 640 improves approval odds and interest rates offered. Steady jobs and home equity make secured loan options more accessible.