Without a doubt, allowing outstanding debt to sit in your account(s) proves to be both risky and costly. Every single month that goes by without paying back the money that was loaned to you leads to the build up of interest charges that you have to pay to your creditor(s). These bills usually take up a significant portion of your budget and can take years to pay off. Since they take up such a significant portion of your budget, you might find that an unexpected expense (such as a medical emergency) may result in financial distress.
Such scenarios are what make financial programs such as debt consolidation valuable because debt consolidation can help you avert challenging financial situations. If you find yourself already in a challenging situation, debt consolidation enables you to overcome these challenges with little difficulty. In this post, we talk about what debt consolidation is and how it can help you as an individual regain control and maintain authority over your finances.
What Exactly is Debt Consolidation?
In elementary terms, debt consolidation is a financial process that combines multiple unpaid debts into a single monthly installment or payment. Therefore, instead of paying four different bills, each one with different interest rates (usually high-interest rates), you get to pay one bill that funds the repayments for all the debts involved in your consolidation plan (and usually has a much lower interest rate).
The Two Primary Goals of a Debt Consolidation Plan
1) To simplify your payment schedule and therefore helps you to eliminate the struggle of having to make multiple payments per month.
2) To lower the interest rate on your debt which enables you to remove the debt much more quickly and save a lot of money.
In most instances, debt consolidation will lower the amount you have to pay each month, but it is advisable to still put as much money as possible towards your payments each month so you can pay off the debts much faster.
Eliminate Your Debt Faster While Paying Less
At first, the statement that you can pay less each month and be able to pay off your debt faster than you would have if you hadn’t consolidated your debt sounds counterintuitive. However, the reason this happens is because of the second goal of debt consolidation which is reducing interest.
When a reduced interest rate is applied to your consolidated debt, a bigger portion of each monthly repayment goes towards paying off and reducing the actual balance owed rather than paying off accumulated interest charges. In simple terms, even though you are paying less than the total amount you used to pay per month before consolidation, the interest is now much lower so you will end up paying off the debt much faster. Having a reduced interest rate is like getting a discount. The extra amount that you would have paid before the discount, in this case, allows you to pay less per month because it goes towards repaying your overall debt.
To illustrate this, let’s say you have a total of $5000 in credit card debt and you have five different cards. If you get an average APR of 18%, you would have to pay roughly $125 each month. However, approximately two-thirds of each payment you make will get “eaten up” by interest fees. Therefore, you pay $125, and $75 goes to interest charges and $50 goes towards repaying the actual debt owed. In this case, even though you paid $125 as repayment each month, your debt is only reduced by $50.00
In the scenario above, it would take 273 months to completely pay off the debt on a minimum payment schedule. Based on traditional minimum payments, it would take a little over 22 years to clear such a debt.
Let’s consider the same debt in consolidation. If you consolidate all five loans into one debt consolidation loan of $5000 at a 5% APR for 60 months, this will result in a reduced monthly installment of about $95. Because of the reduced interest rate, only $20 goes to interest charges and the remaining $75 contributes to the repayment of the actual debt (principal).
You can now see how it is possible to clear your debt sooner even though the monthly installment is lower in the case of the consolidated debt. With a debt consolidation plan, you end up paying off a larger portion of the principal debt than you would have to pay if you chose to not consolidate your debt. In the debt consolidation case above, you completely pay off your debt in 60 payments (approximately 5 Years). These examples prove that debt consolidation offers individuals a fast and efficient approach to eliminate debt.
What Can Be Consolidated?
Debt consolidation usually lets you consolidate similar types of debts. For instance, if you have several federal students loans, you can consolidate those using a Direct Consolidation Loan. If you have multiple credit card debts, you can consolidate your credit card debts with a debt management plan. However, you can’t consolidate credit card debts with student loan debts (unless you find a private company willing to do an unsecured personal loan for you). Different types of loans or debts are considered incompatible when it comes to debt consolidation.
Here’s a few examples of what you can consolidate:
Credit card balance transfer– This is a DIY type of consolidation plan that involves the transfer of existing balances to a low-interest credit card. Some credit card balance transfers offer the advantage of a 0% APR introductory period. However, this advantage is only applicable to credit card debt.
Unsecured personal debt – This plan involves taking out a personal debt consolidation loan and using the money to pay off debts. This consolidation plan offers flexibility in that you can use the money received from the unsecured personal consolidation loan to pay off different types of debt. The flexibility helps you find a way around the debt consolidation restriction where you can only consolidate similar types of debts. This particular type of debt consolidation usually consolidates credit cards, personal loans, medical bills, payday loans, and even store accounts (furniture or electronics). If some of the loan money is disbursed to your account instead of directly to your creditors, that’s when you may choose to utilize it to pay any debt reduction you wish, including debts such as your auto loan.
Debt Management Program-This is a type of debt consolidation that offers assistance to debt consolidation customers through credit counseling. It applies to individuals with all kinds of debts such as credit card debts, eligible payday loans, store accounts, medical bills, student loans, and personal debts already passed to collections.
Home equity loan– A home equity loan refers to a special type of loan whereby a homeowner borrows money against the equity built up in the property. The money received from successfully applying for such a loan can be used to pay off different types of debts. A home equity loan intended for settling debts is the equivalent of an unsecured debt consolidation loan, except the fact that your home acts as collateral to secure the loan. Home equity loans are risky, especially when you use such a loan to settle credit card debts because it exposes your home to the risk of foreclosure.
Direct Consolidation Loan– This refers to the type of debt consolidation usually applied to student loan debts. The name comes from William D. Ford Direct Loan program that gives federal student loans. As long as you have at least one Direct FFEL in the list of student loans that you want to consolidate, you can use this type of debt consolidation.
Private Student debt consolidation loan– This loan allows you to consolidate private and federal student loan debts into a single debt. However, it’s not recommended to convert federal student loans to private. The consequence of turning federal student debt to private debt is that you lose access to federal repayment plans and you become exempt from loan forgiveness programs.
Federal tax debt installment agreement – Some people have multiple years of taxes they owe to the IRS. If you fall into that category, you can roll the tax debts into one single repayment plan.
Debt consolidation is a viable option for those looking to manage debt and eventually eliminate it in the shortest time possible. You have learned that there are different debt consolidation programs with each one best suited to consolidate and manage a specific type of debt(s). Before choosing any debt consolidation program, always ensure that you have assessed your debt situation thoroughly and pick a consolidation program that will yield the greatest benefits. Remember, the worst financial decision is staying in debt when there are viable options to help you pay off debt such as debt consolidation