What Is Debt Consolidation And How Does It Work?

Last Updated: October 24, 2017 in Loans • 

Debt consolidation is the process of totaling-up all of the money you owe to your creditors and obtaining a loan for the total amount. You use the loan to pay off the balance owed to each creditor and going forward, make one loan payment to a single lender. The goal is to lower your monthly payments and make it easier for you to pay your bills by freeing up some cash.

Most loans are structured so that your payment is the same every month. You know exactly what it will be because the interest rate does not vary. If you can obtain a loan with an interest rate lower than what you pay to your credit card companies, you can save hundreds of dollars in interest payments. Freeing up a bit of extra income in your budget will help you make your payments on time and avoid high fees associated with missed or late payments.

Is A Debt Consolidation Loan A Good Option For You?

Debt consolidation loans are designed to help you pay off your high-interest-rate debt with a lower-rate loan that combines all or most of your debt into one loan. By consolidating your debt into a low-interest rate loan, you can pay down your debt faster and watch your credit score go up. You’ll need to evaluate whether you can lower the interest rate you are currently paying on your credit cards. If you are already paying a low rate, making payments on time to avoid penalties, and paying down your principal balance each month, you may not need or want a consolidation loan.

  • Compare how long it would take you to pay off your current debt as-is with the length of a consolidation loan
  • Understand how much interest you will pay over time for each situation and whether paying more in interest is worth having some breathing room in your budget right now
  • Compare how much you are currently paying each month with how much your monthly payment would be with a consolidation loan
  • Keep in mind that one reason you would want a loan is to lower your monthly payments

A debt consolidation loan can help you eliminate the major issues many people with credit card and personal-loan debt face.

  • Eliminate High Interest Rates – Many credit cards for people with bad credit charge extremely-high interest rates, often over 20%. These rates make it almost impossible for you to pay off your debt. Many people are never able to do it because they can’t even make a dent in the principal balance. Almost every dollar you pay goes toward interest only. A consolidation loan will help you pay off these high-interest balances with a lower-rate loan.
  • Avoid High Monthly Payments – If you have a lot of debt, chances are that you are making very high minimum monthly payments on your credit cards and on your other loans. It can be overwhelming to try to make all of these high monthly payments on a limited income. A consolidation loan eliminates the high monthly payments you make by paying off these credit card balances. Instead, you make one monthly loan payment at a significantly lower interest rate than the credit card company charged you.
  • Stop Feeling Overwhelmed – It’s overwhelming to keep track of when you need to pay your bills. Hoping that you have the income to pay them on time becomes another issue. It’s often easier just to put the piles of envelopes in the corner and avoid them—until you can’t. A consolidation loan can help relieve the stress of living from paycheck to paycheck by lowering the amount of money you must pay each month for several, high-balance bills and reducing how often, and how many, bills you need to pay.

Where Can You Get A Debt Consolidation Loan?

There are a few options for obtaining loans. Here are the most common:

Home equity loans

You use the equity in your home as security for a consolidation loan. However, if you do this, you must be aware that the lender can try to foreclose on your home if you miss payments.

Debt consolidation companies

These companies manage the payments you make to them and distribute your payment to your creditors. They will take a monthly, lump sum payment from you and try to negotiate with your creditors to reduce your debt. Investigate these companies carefully if you choose to work with them.

Secured loans

You may be able to obtain a personal loan from a bank or credit union, or even a private lender in the marketplace, if you guarantee repayment by giving the lender a security interest in some valuable personal property, like antiques, cars or household goods.

Unsecured debt consolidation loans

You may be able to obtain an unsecured loan from a bank or credit union. Rates on unsecured loans are generally higher than on secured loans but you won’t have to risk losing your home or other valuable property if you default.

Consolidating Debt Can Help You Live Stress-Free

Most people who face unmanageable debt are able to move forward while paying off their consolidation loans. Keep in mind that you are not eliminating your debt. Instead you are paying it off at a lower interest rate and making a monthly payment that is more affordable over a longer period of time. Use any excess savings to pay down the principal balance on your loan.

Eventually, you will pay off your debt and rebuild and improve your credit score, while giving yourself some peace of mind.