What is debt consolidation and how does it work?

Loan application for debt consolidation
If your debt keeps mounting, you might want to consider debt consolidation to get things under control.

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If you have mounting debts, you are probably not alone. According to recent data from Experian, Americans had an average debt of $96,371 in 2021 — a 3.9% increase from the year before. This number includes credit card debt, loans, and other types of debt.

If you’re feeling overwhelmed by debt, now is a good time to take steps to pay it off quickly. There are several online tools that can help you get back on track in a timely manner.

One method is debt consolidation, which allows you to consolidate multiple debt balances into a single account, ideally at a lower interest rate. By doing this, you may be able to save on interest, lower your monthly payments, and pay off your debt faster.

Let’s take a closer look at debt consolidation, how it works and how it can help you save money.

What is Debt Consolidation?

Debt consolidation provides an easy way to address debt by combining multiple debt accounts into a single account, usually a consolidation loan. You can consolidate student loans, Credit card Debt, unsecured personal loans and other accounts.

To learn more about debt consolidation loans, visit an online marketplace to compare the loan options available to you and determine which one suits your needs.

Not sure if debt restructuring is right for you? Here’s a breakdown of the different reasons you should consider consolidating your debt:

  • Keep your finances simple: The average cardholder has four credit cards, according to Debt.org. Debt consolidation makes managing your finances easier by replacing multiple debt accounts with one account, one interest rate, and one monthly payment.

  • Lower your interest rate: Federal Reserve data shows that the average credit card interest rate will be around 16% in 2022. However, cardholders with significant debt could pay 20% to 30% interest or more. In contrast, interest rates on a debt consolidation loan range from 6% to 20%, depending on your credit rating, Debt.org reports. With a reliable income and good credit, you may be eligible for a consolidation loan at a reduced interest rate, which could lower your monthly payments and shorten your payback period.

  • Speed ​​up your repayment schedule: If you qualify, a debt consolidation loan could lower your interest rates while potentially shaving several months off your repayment schedule.

If you are not sure what Range in which your credit score falls, consider filling out an online form – after all, having good or excellent credit can make a world of difference to you financially. If you’re stuck in the bad or fair zone, there is some steps you can take to improve your score.

How Does Debt Consolidation Work?

When you consolidate your debt, you typically get one large loan that covers all of your combined debt from your other loans and credit card debt. As a result, you only have to make one payment instead of multiple. Sounds easy right?

Keep in mind that debt consolidation loans can come with higher interest rates, additional fees, and longer repayment periods. Before you sign a debt consolidation loan, review the terms of the loan to ensure you’ll save money in the long run.

Applying for a debt consolidation loan typically involves the following steps:

  1. Shop multiple lenders to ensure you get the lowest interest rate possible.

  2. Fill out a loan application.

  3. Provide any additional documents the lender may request to verify your income, bank accounts, and other information.

  4. The lender evaluates your application, credit report, and receipts.

  5. The lender will approve or reject your loan application.

  6. If approved, the lender can pay off your debt accounts for you. Sometimes the lender can fund your bank account or give you a line of credit, and you pay off your accounts yourself.

Common types of debt consolidation

While there are many ways to consolidate your debt, the most common method is by taking out a debt consolidation loan to pay off your balances or by using a credit card to transfer the balance.

Debt Consolidation Loan

A remortgage loan is a fixed rate installment loan where you repay the loan in monthly installments over a set term. To qualify for a debt consolidation loan, you must have a steady income and at least a decent credit history. A credit score of 740 and above may be required to get the lowest interest rate.

Credit card transfer

If you have good credit, you may qualify for a money transfer credit card, which offers a 0% interest introductory period that can last anywhere from 12 to 21 months, Experian says. You can transfer all your debts to this card and pay off your credit interest-free during the introductory period.

However, remember that once the introductory period is over, the regular Annual Percentage Rate (APR) will apply. Also, keep in mind that these credit cards come with a transfer fee that usually ranges from 3% to 5% of the transfer amount, with a $5 minimum fee. If you only have a small amount of debt to transfer, the savings you receive cannot exceed the transfer fee for the balance.

Alternatives to debt restructuring loans

While debt consolidation loans and balance transfer credit cards are commonly used to combat debt, other consolidation options are available, each with varying degrees of risk.

  • Private loan: Unlike debt consolidation loans, whose primary function is to pay off your debt, personal loans are not tied to a single purpose. You can use the funds from a personal loan for various purposes.

  • Home Loans: If you have enough equity in your home, you can access that equity to pay off debt through a home equity loan or line of credit (HELOC). Home equity loans typically offer lower interest rates than other options, but that’s probably because your home is used as collateral for the loan. A home equity loan is risky because if you default on the loan, you could lose your home.

  • 401(k) loans: It might be tempting to withdraw funds from your retirement plan – mainly because you probably won’t need to pass a credit check – but doing so could be classified as an early withdrawal and trigger taxes and penalties. A 401(k) Loans might be a better option as you can avoid the tax penalty. Before taking any money out of your retirement plan, contact your plan administrator or contact a financial advisor for advice.

  • Debt Management Plan: You can create a debt management plan by working with a nonprofit credit counseling agency. In this case, a credit officer will contact your credit card company and try to negotiate lower interest rates and monthly payments, usually three to five years.

  • Debt Settlement Plan: You should only consider a debt settlement plan as a last resort. A debt settlement plan differs from a debt consolidation loan because a debt relief company negotiates with your creditors to lower your debt for less than what you owe, rather than shifting your debt to an account. These companies often charge a hefty fee for their service. Debt settlement plans are risky because they can seriously damage your credit score, and you could owe taxes since any debt forgiven is considered taxable income.

Debt consolidation can make sense if it helps you simplify your finances and comes with a lower interest rate that can save you money. Just remember to check the interest rate, terms and fees before accepting any loan or credit solution.

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