How Does Debt Consolidation Work? The Complete Guide

by Aditya dige
How Does Debt Consolidation Work

The average American has over $50,000 in debt spread over several types of loans. These loans can go from student debt to medical bills, auto loans, payday loans, credit card loans, personal loans, title loans, among others. The thing is, having several loans from different creditors and multiple monthly payments can be nothing short of overwhelming.

This is where debt consolidation comes in. How does debt consolidation work? Debt consolidation allows you to pay off all your pending loans and leaves you with just one monthly payment.

If you get it right, getting rid of debt can be easy with lower interest and lower monthly payments. Keep reading to find out everything you need to know about debt consolidation.

What Is Debt Consolidation?

Debt consolidation is the process of combining several loans into a single debt, leaving you with a single monthly payment. The best thing about debt consolidation is that it reduces the number of bills you have to pay every month and makes budgeting easier. Even better, it reduces the number of creditors you have to deal with, which can be a big relief because creditors can be hounding.

When done right, debt consolidation can help you save money by lowering your overall interest rate and your monthly payments. If you’re lucky, it’ll reduce both, in which case it will be easier for you to pay off the loan much faster, boosting your credit score and the process.

Most debt consolidation loans are fixed-rate installment loans. This means that they come with a fixed interest rate that will not change, and you’ll have a set number of equal monthly payments.

What Are the Different Types of Debt Consolidation Loans?

Before you understand how debt consolidation works, let’s look at the different types of debt consolidation loans. It’ll help you understand which type of debt consolidation could meet your individual needs.

Credit Card Balance Transfers

Credit card balance transfers are quite common, and all you have to do is take out a new credit card and transfer all your existing balances to it. This works a lot better when you get a card with a low introductory interest rate, leaving you with a single monthly credit card payment. Depending on the credit card you qualify for, you may be able to reduce the interest rate even to 0%.

When choosing a new credit to transfer all your balances, it’s vital to make a few considerations. First of all, check the applicable transfer fees. From there, check the transfer deadline, available interest rates, aren’t any consequences of missing payments.

Student Loan Debt Consolidation

Student debt consolidation, on the other hand, combines multiple federal student loans into one government-backed loan. Given the fact that student loans are plaguing about 43 million Americans, student loan consolidation is very common.

Apart from simplifying and lowering your monthly payments, you may be able to qualify for certain borrower protections such as PSLF or Public Service Loan Forgiveness.

Debt Consolidation Loan

Debt consolidation loans are similar to personal notes that you can use to lower your interest rate, improve long-term, and streamline your payments.

These types of loans are essentially available from traditional banks or credit unions. Of course, it’s easy to find online creditors specializing in debt consolidation loans.

When you decide you want to take out a debt consolidation loan, it’s important to compare available lenders, loan terms, interest rates, and fees. You’ll find that online lenders offer pre-qualification processes that allow borrowers to see what interest rates they qualify for before applying for the loan.

Home Equity Loan

Consolidating debt is also possible with a home equity loan. The process involves taking out the loan secured by the equity of your residential property. You’ll receive the money in a lump sum and use it to pay for all other debts.

Once you get the money, you must pay interest rates for the entire loan. However, since your home serves as collateral, it’s likely going to have a lower interest rate compared to any other loans you’re paying for.

Cash-Out Mortgage Refinance

If you already have a mortgage, you can refinance it for more than your outstanding balance. This will enable you to withdraw the difference and use it to pay all your outstanding debts.

You can then roll your other debt payments into a single payment with a mortgage. Given that your home will secure the loan, the interest rates are likely to be lower compared to your original debts.

How Does Debt Consolidation Work?

If you decide you want to consolidate your debt, you will apply for any of the debt consolidation loan types mentioned above through your bank or another lender.

Depending on the lender, you may receive the cash to pay off your outstanding debts yourself, or they may decide to pay off your debts directly. Once all your pre-existing debts are paid off, you’ll start making one single payment on the new loan.

Now, there are a few things you have to understand about consolidating debt. While it’s likely that it will lower your monthly interest rates and payments, it doesn’t always happen.

There’s a chance that you’ll have to pay higher interest rates. Lower monthly payments also mean the loan will extend for a longer duration, meaning it will take you a long time to pay off the loan.

Debt Consolidation Vs. Debt Settlement

A lot of people use debt consolidation or debt settlement interchangeably as if they mean the same thing.

However, there are very significant differences that you have to understand if you’re considering consolidating your debts. Debt settlement is the process of hiring and paying a third-party company to negotiate your loans with your creditors.

Most debt settlement companies charge high fees of up to 20% of the total debt amount, and a lot of them are scammers.

On the other hand, debt consolidation is a process where you personally apply for a debt consolidation loan and pay off your outstanding balance yourself. You’ll take inventory of all you’ve done and develop a strategy to pay them off in a less expensive way. It’s of absolute importance that you understand how to consolidate debt before you take out a debt consolidation loan.

Should You Take Out a Debt Consolidation Loan?

Whether debt consolidation is a good idea hinges on several things you have to consider. Consolidating debt can be a good idea if you know you are committed to paying off your debt as you have sufficient cash flow to cover the payments.

It’s a good idea if you are comfortable with paying the loan over a longer period, your credit score has improved, and you have a solid plan to avoid accumulating debts again.

On the other hand, debt consolidation will not work if you don’t plan to avoid new debt and don’t have sufficient income to cover the new monthly payments. If all your outstanding debts can be paid off in a year, then you may not have enough to consolidate. If you can pay off your debts through debt snowball and debt avalanche, then you can avoid debt consolidation.

What Are the Benefits of Debt Consolidation?

Some of the most significant benefits of debt consolidation are saving money and streamlining monthly payments. Consolidating debt will make it easy for you to manage debts as you’ll have one single payment every month.

Even better, it may lower your overall interest rates and monthly payments. If you get a fixed loan payment, then you may be able to pay off your debt much sooner, especially if you’re consolidating a considerable amount of money.

The Downsides of Consolidating Debt

There are a few downsides to consolidated debts, starting with the fact that you may have to put up your home as collateral. Debt consolidation doesn’t always guarantee lower interest rates, especially for borrowers with poor credit scores.

Even worse, a longer repayment period could mean a higher overall cost, and if you don’t improve your approach to money management, it’s very likely you’re going to accumulate more debt. Beyond that, you’ll have to pay balance transfers, closing fees, or loan origination fees charged by lenders.

How Do You Apply for a Debt Consolidation Loan?

Applying for a debt consolidation loan is an involved process that requires a bit of legwork. You need to get it right and obtain the right debt consolidation loan to avoid burdening yourself further.

It’s important for you to pull your credit, compare multiple debt consolidation loan lenders, and weigh what type of debt consolidation loan will work best for your case.

The first thing you have to do is understand your finances. If you have a strong credit score, then you have a better chance of qualifying for good interest rates. From here, go shopping for the best deals by getting quotes from multiple lenders and comparing lender terms, rates, fees, and monthly payments.

The next step involves getting prequalified and getting a sneak peek of the kind of offers you receive from various lenders. Once you find the right lender, such as Plenti, gather everything you need to apply.

It could be anything from your contact information, pay stubs, and social security number. Upon approval, pay off all your outstanding debts. Prepare yourself to make lifestyle changes that’ll help you avoid accumulating additional debts.

How Does Debt Consolidation Work? Everything You Need To Know

So, how does debt consolidation work? Essentially, by paying off all your outstanding debt, leaving you with one monthly payment. With the right lender, this process can be a lifesaver and could make paying off the loan much easier.

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