Debt consolidation is the process of taking a new loan to pay off all existing debts. Debt consolidation loans are often used by those who have taken multiple unsecured loans and are finding it challenging to maintain multiple EMIs and repayments. These include multiple credit cards, personal loans or other borrowings taken from private lenders who charge high interest rates. A debt consolidation loan helps reduce one’s monthly payment obligations by reducing the overall applicable interest rate.
Here, we will explain all you need to know about debt consolidation and some of the important aspects to keep in mind while applying for one.
What is debt consolidation?
A debt consolidation loan accumulates all existing unsecured loan obligations and combines them into a single loan. This is often done by taking a new personal loan at a comparatively lower interest rate. The idea is to establish a manageable monthly fee to be paid over a set duration. This allows borrowers to pay less interest and get out of a debt trap in a reasonably lesser time.
How is debt consolidation helpful?
A debt consolidation loan helps in reducing the interest component of all loan obligations combined into one. Debt consolidation mainly:
- Reduces the time required to clear off all debt
- Allows one to manage a single EMI instead of multiple monthly payments
Debt consolidation can be done by:
- Taking a secured line of credit
- Opting for a balance transfer with a new lender
- Merging existing debt into a single personal loan with low interest
What are the Different Types of Debt Consolidation?
There are two broad categories of debt consolidation:
- Through Secured Loans – Borrowers can consolidate debt into a single secured debt by going for a mortgage loan, loan against property, loan against car, equity, gold, life insurance policy, cash, etc. The main advantage of secured loans for debt consolidation is that it comes with a lower rate of interest. Since the loan is secured, it is affordable and is often available easily since it is less risky.
- Through Unsecured Loans – For those who don’t wish to pledge any collateral against the loan, an unsecured loan for debt consolidation is an ideal option. Many banks offer unsecured debt consolidation with an interest rate that is often higher than a secured loan. Some lenders may even be willing to waive off interest rate in the first month or a lower interest rate depending on the customer profile. The main benefit of unsecured debt consolidation is that the borrower’s personal belongings are not at risk.
Important Things to Note Before Opting for Debt Consolidation
Here are some of the disadvantages of debt consolidation that every borrower must make note of:
- Can Increase Debt: If a debt consolidation loan is not well-planned or researched, it can affect one’s finances negatively. This is especially true when a borrower cannot manage the new loan properly. Hence, to make the most of a debt consolidation loan, it is important to plan the repayment of the new loan before opting for it.
- Lack of Savings: Most borrowers opt for debt consolidation loans in the hope of saving money that would otherwise go towards multiple debts. However, a debt consolidation loan may not be an ideal choice for all. To ensure savings through debt consolidation, it has to be researched well and borrowers must compare all the available options while also calculating the total borrowing cost with the help of an EMI calculator. Even a low-interest rate on a debt consolidation loan may end up using the same amount of money in the loan term.
- Prepayment fees increase expenses: A debt consolidation loan can help in closing existing loans. This means a borrower may have to pay pre-closure fees to existing lenders. This can add to the total expenses instead of reducing them. Hence it is important to check for the pre-closure charges with existing lenders before taking on a debt consolidation loan.
Remember with debt consolidation, you get a single loan to pay off all of your smaller loans/unsecured loans. The process is quite helpful and reduces your financial stress, however, before you come to any conclusion it is important to know the pros and cons.
Common Mistakes People Make While Using Debt Consolidation Loans
Experts suggest that many people who use debt consolidation loans often fail to comprehend the issue at hand. While using debt consolidation, one must closely scrutinize the situation at hand and how it has arisen in the first place.
It is important to assess all available options before using a debt consolidation loan. There are several alternatives to debt consolidation, such as merging all credit cards into a single one, requesting a new credit line or subscribing for a secured/unsecured loan from the existing bank.
If a borrower fails to curb his/her access to credit, there are chances of larger troubles to come. Debt consolidation must be conducted appropriately else it can turn into a gamble. There should always be a plan to repay debt consolidation before signing up for it. A debt consolidation loan can take a long time to repay especially if a borrower makes only minimum monthly payments. With a budget that is dedicated to debt repayment, one can assign funds to it and ensure a timely repayment.
Those who want to be debt-free fast must transfer additional bonuses, tax refunds, cash gifts or other additional remuneration towards the debt account to close it on time.
Debt consolidation is a double-edged sword that has to be used with utmost care. While it can help those who are facing multiple debt repayment issues it can cause trouble for those who use it in an unplanned manner.
- Do consolidation loans hurt your credit score?
Debt consolidation can help in lowering monthly repayments towards loans or credit cards; however, it can also result in a temporary lowering of credit score. The impact on credit score depends on the credit discipline adopted by the user or borrower.
- Is it smart to consolidate debt?
Debt consolidation combines multiple debt obligations into a single payment. It can prove helpful if it comes with a low enough interest rate. This helps in reducing total debt obligation and reorganizing it to ensure faster repayment.
- Why is debt consolidation a bad idea?
Consolidating debt with bad credit may do further damage instead of improving a borrower’s situation. If an individual’s credit rating is low, it may be difficult to get a debt consolidation loan at a lower interest rate. Debt consolidation with a high-interest rate can worsen the financial situation instead of improving.
- Is it better to get a personal loan or debt consolidation?
A personal loan for consolidating debt can make debt repayments easier and less expensive if it has a lower interest rate. This is because the combined rates on individual loans could be far higher than a single personal loan with a lower interest rate. One can consolidate different kinds of loans using a personal loan.
- Can I still use my credit card after debt consolidation?
Debt consolidation results in the closing of different credit card accounts. Depending on whether you choose to consolidate all credit cards or some, you may still be able to use your credit card post debt consolidation.