FAQ’s About What Debt Consolidation is REALLY All About
When you are bogged down by debt and feel like there is know what out, debt consolidation might seem like the answer to your problem. Debt management companies may very convincingly sell you on the idea, but really it’s just another loan. And as anyone with debt knows, loans do not save you money. That’s not to say debt consolidation is never the answer, or that it can’t be right for you. However, you do have to be careful. The truth about debt consolidation is that it’s not always good. It’s a lot trickier to use as an effective way to eliminate debt than it’s portrayed by the banks. Here are some helpful ways of understanding debt and how consolidation can help or hurt your situation.
Your Credit Score
Your credit score is not that important. Let’s start there. If you are drowning in debt and looking for a lifeline, you don’t need good credit. High credit scores help you borrow money, they don’t help you pay it off. The only exception is when you want to borrow money to pay off debt at a lower interest rate. That’s where debt consolidation as a strategy enters the scene. Generally speaking, you should not be borrowing any more money while you are trying to pay off debt. The process of paying off debt naturally increases your credit score. So, it all works out the way it’s supposed to. If you do consolidate debt, it is likely to result in a short term dip on your credit score, but if you pay off the debt, all will be restored.
What that means is that you should be careful whenever your focus shifts from paying off debt to improving your credit score. That rating is just a means to an end. It’s emblematic of consumer power and consumption should be minimized while you are working hard to become debt-free. If you are looking for a lifeline in the form of a consolidation loan, please be fully aware of your current financial situation and the terms you are considering a transition to. With all debt, your biggest adversary is interest. You need to understand how it relates to your balances and the new loan you are considering.
Balance to Interest Ratio
Interest rates are referred to in terms of low and high. You have a prime rate which is a standard interest rate for preferred borrowers and you are likely going to get a rate somewhere above that up to nearly 40%. Interest rate is a good indication of the quality of the loan, but it’s only part of an equation. To fully understand the value of the interest, you need to know the balance that that percentage rate relates to.
Multiple Interest Rates
Part of the appeal of consolidating debt is having it all in one place and making only one monthly payment. Without interest, this is a good plan, but loans don’t exist without some sort of return on investment for the banks. Every balance you have has an interest rate, and that consolidation loan will also have an interest rate. Where it gets tricky is how each of those percentages relates to their unique balances. Are you paying 17% interest on a $1,500 line of credit? 5% on a $30,000 car? How much total interest are you paying to each of your accounts and once that balance jumps to one behemoth account what will the interest rate be then?
Low Rate – High Balance
The greatest danger of Debt consolidation is how much you will increase your debt just by adding up all of your balances into one lump sum. If you have a low-interest rate, but a high balance, that dollar amount that you actually have to pay in interest turns out to not be so low. Moreover, if that credit score has taken a hit due to your outstanding debt, then the quality of loan you are able to get will not be all that favorable. You could end up owing much more in interest than you can afford and only drive yourself deeper into debt.
There are instances where you can take out a line of credit that has a higher limit than your combined accounts and comes with a 0% introductory rate. This is the best-case scenario, but you still have to be careful. At a certain point, the introductory rate ends and your interest shoots up. You should not enter into this arrangement without working the numbers and coming up with a game plan for paying off your debt or at least getting the balance really low by the time the clock runs out on that 0% rate.
The Scale of Consolidation
How good of an idea it is to consolidate your debt could boil down to how big your debt is. The amount you owe and are trying to pay off can determine your approach to debt consolidation and whether or not it’s worth it. There are three main approaches to consolidating debt. Credit cards, personal loans, and debt consolidation loans.
High Limit Credit Card
The best-case scenario is that you have a few cards with varying balances and interest rates and you discover you qualify for a higher balance on a card with an introductory 0% APR. You do the math and discover that by making one interest-free payment for the next 12 months, you will have your debts completely paid off. This is great for consolidating credit cards, but other debts such as auto loans will remain separate. If you can’t make this transaction work on paper, then you should avoid consolidating.
A personal loan is tougher, but it gives you more latitude to pay off any loans you have. So if you are accepted for a personal loan, you can use it to pay lines of credit, auto loans and anything else. Although you can pay off more at once, you should still be careful about what your new monthly payments will be and how much of that will be going just to interest. You should have a realistic timeline of when the new loan will actually be paid off and a workable game plan for reducing that length of time as much as you can.
Debt Consolidation Loans
Finally, we come to debt consolidation loans. These loans do not give you as much license as a personal loan. They will only include unsecured debt, not auto loans or other secured loans. Debt consolidation loans have attractive low-interest rates, but that is because your aggregate balance will be so large. That low percentage is going to count for more.
Instead of using a consolidation strategy to pay off debt, you should create a debt hit list and target your balances one by one based on high to low-interest payments. This method is what will get you out of debt the fastest because it starves high-interest rates by reducing the balances they feed on. The lower you get the interest payments the faster the balance goes down. That’s why tackling high interest first is so important and why you shouldn’t be distracted by low balances that are easy. to pay off, or paying several balances only to have one much bigger balance.
Have you ever consolidated your debt? If so, what’s you learn from the experience? Tell us in the comments! And, if you post this post helpful we’d be so thankful if you shared it with your friends!