How Does Debt Consolidation Work?

How does debt consolidation work

Have you ever considered getting a debt consolidation loan? Or wondered what the heck a debt consolidation loan is? You’re not alone! Our goal on this blog is to assist you in understanding complicated financial questions and to help you make good decisions when you’re working to pay off your debt. And since debt consolidation is one option that many people with debt are curious about, today we’d like to tackle this question: How does debt consolidation work?

The Theory Behind Debt Consolidation

The purpose of debt consolidation is to allow people who are having trouble managing various debts to consolidate, or group, all their debts into one.

Many people find it easier to manage one loan rather than trying to deal with several different bills each month. And by grouping all your loans into one larger loan, you can often obtain a lower monthly payment or lower interest rate. For example, if you have three credit cards with interest rates of 12%, 18%, and 25%, you might be able to consolidate those three accounts into one loan with an interest rate of 10-15% – which would save you money.

Likewise, a debt consolidation loan can also lower your minimum payment, which is especially helpful for people who are having trouble making that payment every month. If you are incurring penalties because of missed payments and need more breathing room, then a debt consolidation loan can help you tremendously. However, it’s important to keep in mind that a lower monthly payment means you’ll pay more interest in the long run.

Where to Get Debt Consolidation Loans

Most debt consolidation involves credit card balances or student loans, although it can also work for other types of debt. (If you’re thinking of consolidating student loans, read our blog post, How Does Student Loan Consolidation Work)

When it comes to debt consolidation loans, there are several types of companies that provide them, including:

  • Mortgage lenders
  • Credit card companies
  • Peer-to-peer lenders
  • Debt management/credit counseling companies
  • Banks

Mortgage lenders often provide consolidation loans that use your home as collateral for your debt. This type of loan is known as a Home Equity Line of Credit (HELOC). In general, a HELOC has a better interest rate than other debt consolidation loans, but is also more risky than the other types of loans because you can lose your home if you fail to make payments as required.

Another option is to use a credit card balance transfer offer to consolidate all your debt onto one credit card. A balance transfer can be very good or very bad, depending on whether you can quickly pay off your debt. Many balance transfer offers give you a 0% interest rate for six to twelve months (after a 3-5% initial fee), which is great if you are able to pay off your debt in that timeframe. But if you do not end up paying off your debt during the introductory 6-12 month period, you will usually be charged interest retroactively on the entire balance that you transferred – including whatever portion you had already paid off!

The Best Option for Debt Consolidation

So… what if you’re not sure you can pay off your debt in the next 6-12 months and you don’t have a mortgage (or don’t want to use your house as collateral)?

We think one of the best options for debt consolidation is through a peer-to-peer lender. Unlike many debt management and credit counseling companies, they don’t charge extra (or hidden) fees. And they often give you better interest rates than you would get from a bank. For example, Lending Club, one of the most well-known peer-to-peer lenders, offers debt consolidation loans with interest rates starting at 6.78%, and makes loans of $1,000 to $35,000. (If you use ReadyForZero, you can automatically qualify for Lending Club loans)

Does Debt Consolidation Hurt Your Credit?

In many cases, debt consolidation does not have a negative impact on your credit. However, as with all loan applications, it generally requires a hard credit check, which takes a few points off your credit score for up to two years. Ultimately, the most crucial thing you can do to help your credit score is to make payments on time and to pay off your debts. If you’re in a situation where you need debt consolidation to help you avoid late payments or exorbitant interest fees, the loss of a few points off your credit score due to the hard credit check is probably not your biggest concern. But it’s still important to be aware of it. Once you have a debt consolidation loan, as long as you make payments on time and adhere to the agreements of your loan, your credit score should only improve.

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How to Know if Debt Consolidation is Right for You

The most important thing is that you reduce your total debt. So it’s only wise to get a debt consolidation loan if it will help you achieve that goal. You don’t want to use debt consolidation simply as a way to make more credit available to you. If you get a debt consolidation loan and then continue racking up credit card debt (or other debt) you’ll be in a very dangerous situation.

As mentioned above, a debt consolidation loan can help you get out of debt if:

  • you currently have high interest rates and would benefit from having a lower interest rate applied to all your debt
  • you need breathing room (i.e. lower minimum payments) to avoid becoming late on your bills
  • you get confused or overwhelmed by receiving too many different bills each month and would benefit from having just one bill

Please see our blog post titled Is Debt Consolidation a Good Idea? for more information that might help you with your decision. If you have further questions about how debt consolidation works, please don’t hesitate to ask us.

This article is part of our Debt Consolidation Resource Center.  If you’re looking for additional information about debt consolidation, be sure to pay a visit!

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