Before deciding to apply, it is important to understand the debt consolidation benefits and drawbacks explained. This will give you insights on how to manage your debt. Debt consolidation could be good for some, but not for others.
It is a common fact that everyone knows. If you want to know more about the pros and cons, here’s everything you should know to make the best choice for your situation. Without any further ado, let’s dig into the article!
What is Debt Consolidation?
Debt consolidation can be a powerful strategy for managing your bills and payments, especially when you have a clear understanding of your financial situation. By consolidating your debts, you can combine multiple payments into one, simplifying your finances.
This approach may also help lower the interest rates on your existing debts, allowing you to pay them off more quickly. Additionally, paying your consolidated debt on time can improve your credit score.
You can consolidate various types of debt, including multiple credit cards or a combination of credit cards and other loans, such as student loans or even a mortgage.
While consolidation doesn’t erase debt, it can provide a more manageable way to pay it off. For many borrowers, it provides the tools needed to tackle their debt more effectively and efficiently.
How Debt Consolidation Works?
Before going to debt consolidation benefits and drawbacks explained, you should know how debt consolidation works. If you owe money to four different lenders, each with its interest rate, the debts might include a $1,500 overdraft, $4,200 in credit card debt, $5,000 on a personal loan, and $1,000 on store cards.
By applying for a $12,000 consolidation loan, and if approved, this amount would pay off all your existing debts. From that point on, you’d make a single monthly payment towards the new loan until it’s fully repaid.
Debt Consolidation Benefits and Drawbacks Explained
Debt consolidation has both pros and cons, and it’s important to understand both debt consolidation benefits and drawbacks explained. Here’s a breakdown of the key benefits and drawbacks to help you make an informed choice.
1. Benefits
Here are a few benefits you can get from debt consolidation.
a. Lower Rate
One of the main benefits of debt consolidation is to reduce the interest rate on your debt. For example, if you have $12,000 in total debt with an average APR of 22% and are making monthly payments of $600, you could end up paying around $3,200 in interest for two years.
However, debt consolidation with a loan offers a 14% APR and a two-year term, your new monthly payment might drop to $570, and you’d save approximately $1,200 in interest.
If you qualify for a balance transfer credit card, you could pay no interest during a promotional period, which could last up to 18 months, though there’s usually a 4% balance transfer fee.
b. Faster to Get Out of Debt
Consolidating helps you to pay all of your debt at once with low interest. For example, if your new monthly payment drops from $600 to $570, you can keep paying $600 each month. This strategy works even better with a balance transfer card, allowing you to reduce your debt.
c. One Monthly Payment
Consolidating your debt makes you only have one monthly payment. It gives you a fixed interest rate that stays the same throughout the loan or the balance transfer card’s promotional period. This makes it easier to manage your debt and become debt-free.
2. Drawbacks
Here are a few drawbacks you should consider before applying for debt consolidation.
a. Unqualified for Low Rate
Balance transfer cards are hard to qualify for because they require a high credit score of around 690 or higher. Debt consolidation loans are easier to access, even for those with bad credit (629 or lower), though those with the best credit scores typically get the lowest rates.
If the consolidation loan doesn’t offer a lower interest rate than your current debts, it might not be the best option. In that case, you might consider other methods like the debt avalanche or debt snowball to pay off your debt.
b. Additional Fee
Debt consolidation loans may include origination fees, usually between 1% and 10% of the total loan amount, often added to the loan’s interest rate. Balance transfer cards typically charge a fee of 3% to 5% of the amount you transfer. If these fees are high, it might be better to explore other debt payoff options.
c. Risk for Missed Payments
Missing payments on your consolidated debt can leave you in a worse situation. For instance, if you don’t pay off your balance transfer card before the zero-interest period ends, you’ll be stuck with a higher interest rate, possibly even higher than what you had before.
With a consolidation loan, missed payments can lead to late fees and damage your credit score. Thus, make sure the new monthly payment fits easily into your budget for the entire loan term before consolidating.
d. Unresolved Main Debt Issue
Debt Consolidation doesn’t fix the main problem when you decide to take debt in the first place. If overspending is an issue, consolidation might not be the best solution. For example, paying off credit cards with a loan may leave your cards with a zero balance, but you could be tempted to rack up new debt before the loan is paid off.
If you’re using credit cards to cover basic needs like food or rent, consider looking for better options, such as local charities that can help with groceries, bills, or housing. A credit counselor from a nonprofit can also assist with budgeting and creating a debt management plan.
Debt Consolidation Benefits and Drawbacks Explained to Make You Debt-Free
Understanding the debt consolidation benefits and drawbacks explained will give you the insight you need to make an informed decision about managing your debt. While consolidation can be a helpful tool, it could lead to higher interest rates or more financial strain in some cases. It’s important to talk to a financial professional to assess your situation and find the best solution for your needs!