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Debt consolidation allows you to consolidate multiple high interest debts into one manageable payment. Find out if this is hurting your credit. (iStock)
If you want to reduce – or simplify – your monthly debt payments, debt consolidation may be right for you. It can help you organize your finances and pay off your debts more easily. With debt consolidation, you’ll combine all of your debts into one payment so you don’t have to worry about multiple payments, interest rates, and due dates.
Like any other financial strategy, debt consolidation is not for everyone. Here’s what you need to know about debt consolidation and its impact on your credit.
If you are considering a personal loan to consolidate your debts, Credible allows you to compare personal loan rates from various lenders within minutes.
How Does Debt Consolidation Work?
With debt consolidation, you consolidate multiple debts into one manageable payment, ideally with a lower interest rate. It can help you streamline the debt repayment process and save on interest. A debt consolidation loan is a type of personal loan.
If you are overwhelmed with multiple debts, such as credit card balances, medical bills, or tax debts, debt consolidation can be a great solution. You won’t have to keep up with the different payments and interest rates, so you can pay off your debt with less confusion.
Debt Consolidation Options
There are several ways you can consolidate debt, including:
- Personal loan – You can take out a personal loan with an interest rate that is lower than all or most of your other debts and use the funds to pay off what you owe. Many financial institutions, such as banks, credit unions, and online lenders, offer debt consolidation loans.
- Loan from friends and family – If you have a loved one with a little extra cash, you may want to consider applying for a low interest loan. You can use the funds to pay off your debts and pay off a family member or friend in just one monthly payment. Just make sure the repayment plan is written down so everyone is on the same page.
- Balance Transfer Credit Card – Once you open a balance transfer card, you transfer your current credit card debt to it. In most cases, the Balance Transfer Card will come with a promotional 0% APR. If you pay off your debt in full during the promotional period, you can avoid interest charges. Otherwise, you will have to pay the balance at the card’s regular interest rate. You will generally need good to excellent credit to qualify for a 0% introductory APR.
- Home equity loan or HELOC – A Home Equity Loan or Home Equity Line of Credit (HELOC) allows you to borrow money secured by your home. It can give you the money you need to pay off high interest debt at a lower interest rate. But if you don’t pay it back, your lender can foreclose on your home.
- Automatic cash-out refinancing – If you have equity in your vehicle, a withdrawal auto refinance replaces your current car loan with a new, larger loan – you can use the difference to pay off your debt. To be eligible for cash-out auto refinancing, your vehicle must be worth more than your remaining auto loan balance.
- Retirement loan – If you have a retirement account like a 401 (k), you can withdraw money from it to consolidate your debt. You will pay yourself interest and the loan payments will usually be taken from your paycheck. Keep in mind that once you withdraw funds from your retirement account, you will lose the power of compound interest on that amount. And, if you don’t repay the loan, you could face a tax bill on the amount you withdraw from the retirement account.
How Debt Consolidation Can Affect Your Credit
Debt consolidation can have both positive and negative effects on your credit.
- Serious inquiries can lower your credit score. When you apply for a balance transfer card or personal loan to consolidate debts, the lender will do a thorough investigation of your credit. This can temporarily affect your credit score.
- Your average credit age will go down. As your credit accounts age and have a history of on-time payments, your credit score will likely increase. By opening a new account, you will reduce the average age of your account, which in turn could lower your credit score.
- Your credit mix will become more diverse. Your credit mix refers to the types of accounts you have, such as credit cards, loans, or a mortgage. Since lenders prefer to have a variety of accounts, opening a new credit card or personal loan can increase your credit score.
- You will reduce your rate of use of credit. Your credit utilization rate is the amount of revolving credit you are using divided by the amount of revolving credit you have available. Since a new debt consolidation account can increase your available credit, it can lower your ratio and improve your credit score.
- One-off payments can improve your payment history. If you make timely payments on your new debt consolidation loan, your credit score will gradually improve. Payment history is the most important factor in determining your credit score, so make sure you never miss a payment.
When it makes sense to consolidate your debt
Debt consolidation isn’t for everyone, but it’s a great option if you’re currently struggling to keep up with your monthly payments. If you are able to get an interest rate lower than your current debt, you can save hundreds or even thousands of dollars in interest over the life of your loan. However, if your repayment term is considerably longer, you could still end up paying more interest overall. Consider these factors before consolidating your debt.
Debt consolidation can also be worth it if you know you can stay on budget in the future. If you pay off your debt with a debt consolidation loan but immediately start accumulating credit card debt afterwards, you will find yourself stuck in the same cycle again.
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How to start
If you decide to go ahead with debt consolidation, check your credit score first so you know where you are at and what types of loans and credit cards you may be eligible for. Next, make a list of all the debts you want to consolidate.
Next, determine the debt consolidation route you want to take. Shop around and compare all your options to find the best rates. Once you’ve chosen the right path for your situation, make sure you make your payments on time.
Alternatives to Debt Consolidation Loans
If a debt consolidation loan isn’t right for you, you can look to other options.
- Create a budget – Sometimes the easiest way to pay off debt is to create a budget and stick to it. You can choose from many types of budgets depending on your needs.
- DIY Debt Repayment Strategies – You can use the snowball or debt avalanche method to pay off your debts on your own. While the Debt Snowball Method focuses on paying off your smallest debts first, the Debt Avalanche Strategy aims to help you save the most on interest by paying off first. your debt with the highest interest rate.
- Debt Settlement – Debt settlement is when you negotiate with your creditors to pay less than you owe. You can negotiate yourself or hire a professional debt settlement company to do it on your behalf. Be aware, however, that paying off debts can hurt your credit.
- Debt Management Plans – Offered by credit counseling agencies, debt management plans are designed to help those with a lot of unsecured debt. A credit counselor will negotiate interest rates, monthly payments, or fees with your creditors. Once done, you will make a payment to the credit counseling agency, which will use the money to pay your creditors. Debt management plans can also hurt your credit if you end up changing the terms of your creditors agreements.
If you have decided to use a personal loan for debt consolidation, visit Credible for compare personal loan rates.