Debt Consolidation (definition)
Debt Consolidation
Debt consolidation is a strategy used to better manage debt problems. When consolidating debt, a consumer typically arranges with a lender to replace several bills with one (larger one, of course), usually resulting in either a smaller monthly payment, and/or a lower interest rate, which will allow more of the payment to go towards reducing the principal rather than the interest.
When consolidating debt, you often achieve several benefits. For example:
- many payments are consolidated into one - that's the whole purpose of this type of loan, get rid of several monthly payments in favor of one smaller one (smaller than the total of the individual payments you're consolidating).
- the average interest rate is reduced - if you're paying 18% or more on a typical credit card, and you can get a loan at 6% or less, you're saving 1% of the amount owed every month! In other words, for every $10,000 that you owe, you're saving $100.00 per month ($1,200 per year!), money which can go either to balancing your budget, or can go to making higher payments on the principal, which will enable the loan to be paid off quicker.
- the monthly payment may be more affordable - in you're in a financial bind, the lower payments might enable you to balance your budget, rather than continuing to borrow against high interest credit cards. As your ability to make larger payments returns, you can then start making larger payments, bringing down the balance even faster.
- you could be out of debt sooner - the way credit card payments are structured, they often never are fully paid off. As the balance comes down, so does the minimum payment, they want you to owe them money because they earn their income on the interest you pay. With a debt consolidation loan, you're asked to pay a fixed payment every month, which means that the lower the balance becomes, the more goes towards principal, and less goes towards interest.
Debt consolidation is often the answer to avoid bankruptcy. It will not have a negative effect on your credit report because you aren't doing anything unethical or trying to avoid your debt.. In fact, debt consolidation might improve your credit score, especially once your other debts are marked as paid in full, and you make a habit of paying the new loan on time every month.
Even in situations where bankruptcy isn't imminent, debt consolidation is a way to get more money back into your pocket, and get out of debt quicker, since the whole purpose of this approach is to lower the average interest rate being paid, which means the principal is paid down faster, which means the light at the end of the tunnel is closer to you.
Like other financial decisions, sit back, relax, and decide if a debt consolidation loan is right for your situation. If you determine that even after consolidating your debt, you'll still be unable to pay your bills, it makes no sense to take several unsecured loans and perhaps convert them into a home equity loan, if doing so will put your principal residence in jeopardy.