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  • Writer's pictureMarc Primo

The Pros and Cons of Debt Consolidation

This is an article “The Pros and Cons of Debt Consolidation” by Marc Primo

Financial pundits have said that you’ll never experience true financial freedom if you don’t acquire passive income. However, there are still times when you have to settle debt payments while you have some passive income. Whether you pay lesser amounts on your personal loans or still find the need to apply for more, being ‘financially free’ is out of the question as long as you have debt.

For many who struggle with debt, one solution seems to be more viable than others. Debt consolidation is a type of refinancing process wherein you take out another loan to pay off your other previous loans. Individuals with high consumer debt can benefit from this form of refinancing process regardless of how much they are currently paying in interest. Debt consolidation simplifies and adjusts your payment terms, and can even reduce the amounts you pay in a month.

How does debt consolidation work?

In a nutshell, debt consolidation takes all of your high-interest debt from credit card purchases, and personal loans, and unifies it into one umbrella loan with a lower interest rate. Depending on your paying capacity, you can also opt for longer payment terms to make settlements more manageable.

By rolling multiple debts into single payments, you can reduce your total loan and restructure your payments so you can pay them off much faster and without any difficulty. You also get to deal with one lender instead of multiple entities. And as many have experienced, dealing with all the due dates that come from multiple loans can be pretty challenging and often leads to incurred interest.

Opting for debt consolidation on your auto loans, credit cards, payday loans, and other personal loans can make things easier for you as you settle them in one unified loan for the long term. But which type of debt consolidation would work best in your situation?

Four types of consolidated loans

By reviewing your credit score, current income, and the amount that can be consolidated, you’ll be able to figure out which debt consolidation process out of these four best suits your needs.

  • Credit card

If you have a credit card, you may use it to combine your loans into one. Most people who choose this option deal with debt from multiple credit cards. Choose a credit card provider that offers the lowest interest rate and transfer debt balances into that one card for faster and easier payments.

If you have a good credit score, credit card debt consolidation providers may even offer a 0% annual percentage rate (APR) for around 12 months. If you are qualified, you get to save more money paying off your debts as they don’t incur interest during the given period. If you are willing to pay off your debt religiously, this is a good option as you are given a long timeframe to settle a bigger portion of the debt at zero rate. However, if you fail to pay them off regularly, interest rates will only go up leading you back to struggling with high-interest debt.

You’ll also have to take into account balance transfer fees which are calculated from the total amount of your consolidated loans. Review these fees and make sure they don’t go higher than the potential money you can save from the zero rate interest time frame. Also, bear in mind that opting for a credit card debt consolidation will automatically affect your credit score. Closing another credit card with a significant balance could increase your credit utilization and, eventually, lower your credit score.

  • Debt consolidation loan

This is a type of personal loan that allows you to consolidate all your debts from other lenders. Payment money for your other loans will be sent to your bank account while you assume a new loan with your new lender that you’ll have to pay off at lower interest.

This type of debt consolidation is usually unsecured with fixed rates so you won’t have to worry about fluctuating interest rates as you pay them off. It is the best option if you have a low credit score because lenders will know best not to offer you higher interest rates. Once you’re approved, you’ll be asked to pay for a processing fee or at times, prepayment penalties. Be sure you review these fees so you don’t end up paying more on fees than potential money you could save from dealing with just one lender.

  • Home equity

The third type of debt consolidation lets you tap into your home equity to combine your multiple loans into one. This one is a secured type of consolidation with lower rates, though you’ll have to place your home as collateral.

Depending on your home equity, you can borrow larger amounts that are calculated via property value minus your mortgage balance. Another factor that will come into play when you’re seeking approval for a home equity loan is your debt-to-income ratio. You can check this by taking the sum of your monthly debt payments and dividing it by your gross monthly income.

One downside to this type of debt consolidation is that you are putting your home at risk since it is listed as collateral. Once you can’t pay your monthly obligations, the lender has the right to take your home to offset your loan payments.

  • 401(k) debt consolidation

While taking out a 401(k) loan may seem like a good way to consolidate your loan balances, it’s one of the riskier options here on the list. Since you’ll be borrowing your own money (assuming you have made enough contributions already and are qualified to take such a loan), you might eventually find yourself falling behind your payments. 401(k) loans also incur interest and if you haven’t reached the retirement age of 60, the Internal Revenue Service (IRS) may impose penalties for early distribution.

Aside from the penalties, you’ll still have to pay for the incurred interest from the loan and should you decide to quit your job or lose it somehow, you’ll be asked to pay for the loan amount in full.

Before taking out such a loan, think about how you might be risking your retirement savings and how you’re stunting its growth by paying off your other loans.

Should you take a debt consolidation loan?

Regardless of which option you choose, debt consolidation loans help you settle your multiple debt payments in a manner that’s simple and manageable. If you have a good credit score and don’t plan to apply for more loans, these are good ideas when you’re seeking financial freedom.

Look for available loans that won’t let you pay origination fees or 0% APR offers then plan ahead so you don’t miss any payments and incur interest rates or penalties. Lastly, always review the amount you are going to part with every month along with their corresponding fees and make sure you’re saving more than what you’re paying.

When it comes to taking out debt consolidation loans, everything boils down to careful planning and creating a feasible budget that reduces debt payments and increases your income.

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