Debt can be a significant source of stress and anxiety, particularly when multiple creditors and high-interest rates are involved. In such cases, debt consolidation is often recommended as a solution to simplify payments and potentially reduce interest rates. However, it’s not a one-size-fits-all solution, and it’s important to know when it’s appropriate and how to go about it. This article will explore the concept of debt consolidation, its benefits and drawbacks, and provide insights on how to decide if it’s the right approach for you. Continue reading online to find out if debt consolidation is the right option for you!
What is Debt Consolidation?
Credit card consolidation is a method where you merge multiple credit card balances into one balance, says Forbes Advisor. This simplifies tracking since there is only one monthly payment and due date to keep track of. Consolidation approaches typically feature a lower Annual Percentage Rate (APR). This will save on total interest paid and enable a person to pay off their balance faster.
If you’re looking to become debt-free, whether from credit cards or other debts, the source recommends seeking advice from an accredited not-for-profit credit counselor, financial advisor, or Licensed Insolvency Trustee who can help you assess your situation. Afterwards they can identify ways to pay off your debt.
How Does It Work?
Consolidating old debt into new debt can be accomplished in various ways, such as taking out a new personal loan, a credit card with a higher credit limit, or a home equity loan. Afterward, you can use the new loan to pay off your smaller loans, explains Investopedia. If you’re consolidating credit card debt using a new credit card, you can transfer the balances from your old cards to the new one. Additionally, some balance transfer credit cards offer incentives such as a 0% interest rate on balances for a specified period, notes the source.
Apart from the potential benefits of lower interest rates and smaller monthly payments, Investopedia states that consolidating your debt may simplify your financial life by reducing the number of bills you need to pay each month and the number of payment deadlines to keep track of.
Ways to Consolidate Credit Card Debt
There are a few options when it comes to consolidating credit card debt. The most common are personal loans, debt consolidation programs, balance transfer credit cards, and a second mortgage or home equity line of credit (HELOC). Here is a short description of each as explained by Forbes Advisor…
- Personal Loans: Consider a debt consolidation loan from a local bank or credit union. They offer flexible terms, consistent monthly payments, and some institutions will pay creditors directly. However, the interest rate and potential origination fees are determined by credit score and loan terms. Some underwriters use non-traditional metrics like education and job history, which could help newer borrowers. Drawbacks include potential fees and fewer loan term options.
- Debt Consolidation Programs: Debt consolidation programs combine credit card debts into a single payment that goes to the program, which forwards the payment to creditors. This is different from a debt consolidation loan. The program’s monthly payment is usually less than individual payments. These programs also work with creditors to reduce interest rates and eliminate fees. However, some programs require closing some or all cards.
- Balance Transfer Credit Cards With 0% Interest: Credit cards often offer 0% APR on balance transfers for a limited time, usually six months to a year, after opening the account. Though balance transfer fees may apply, these cards prevent additional interest during the introductory period. The MBNA True Line Mastercard is a good option with no annual fee, 0% intro APR for 12 months, and 12.99% regular APR.
- Second Mortgage or HELOC: Consolidating debts can be done through a second mortgage or a HELOC if your home’s value has increased or the balance is paid down. These options use your home as collateral, resulting in lower interest rates and smaller monthly payments. However, there may be additional expenses and tax implications.
When Is it a Good Idea?
According to NerdWallet, in order for a consolidation strategy to be successful, a person should meet the following criteria. First, their monthly debt payments do not exceed 50% of their monthly gross income. Second, their credit score is good enough to qualify for a credit card with 0% interest period or low interest debt consolidation loan. Third, they should have sufficient cash flow to make consistent timely payments towards consolidated debt. And lastly, they need to be able to repay a consolidation loan within five years.
The source then goes on to provide this example to show when consolidation is a good idea. Assume you have four credit cards with interest rates ranging from 18.99% to 24.99%. If payments are made on time, their credit score goes up. This will qualify a person for an unsecured debt consolidation loan at 7% interest rate. This is a significantly lower interest rate, making consolidation a viable option.
For many individuals, consolidation provides hope for a debt-free future, says NerdWallet. For instance, people who choose a three-year loan should be confident it can be fully paid in this time. It does require them to manage their spending and make payments on time. On the other hand, the source warns that making minimum payments on credit cards could mean months or years before clearing debt while also accruing more interest than the initial principal.
When is it Not a Good Idea?
NerdWallet warns that consolidation is not a guaranteed solution for debt. It’s not going to solve the root cause which often stem from excessive spending. Additionally, it won’t work for people who are already in over their head and unable to make reduced payments, notes the source.
If debt is relatively small and can be paid off in a reasonable amount of time, then consolidating debt might not be worth it. The reason is because savings will be minimal. Instead, NerdWallet suggests using a DIY debt repayment method like the debt snowball or debt avalanche. Use online debt calculators or work with an expert to explore different strategies. If debt exceeds half a person’s income, then it’s likely the best option. Sometimes seeking debt relief is better than continuing to tread water, says the source.