What is Debt Consolidation?

High-interest debt can be overwhelming, and if you are looking for ways to alleviate some of that stress then a debt consolidation loan may be able to help.

In this article, we will give you the ins and outs of debt consolidation, how it works, and the different types of loans you may want to consider. That way, you are set up to tackle your debt with confidence.

What is debt consolidation?

Debt consolidation is a financial strategy that is used to tackle various types of debt at once. Typically, this method is implemented to combine debt in various forms into a single payment. It can offer significant relief to borrowers who may be overwhelmed by multiple monthly payments.

How does debt consolidation work?

If you are wondering how to consolidate debt, there are two common methods:

1. Applying for a high limit credit card that allows or encourages balance transfers.

2. Taking out a debt consolidation loan.

In the case of a new credit card, some even promote an initial interest rate of 0% for a set amount of time, making them good for borrowers looking to cut down their minimum payments. However, if you have a higher amount of debt, then you may decide to utilize a debt consolidation loan. You can apply and use these new funds to pay off any existing debts and then turn your attention to paying off the single loan.

What is a debt consolidation loan?

The method you choose for the purpose of consolidating debt will depend on the total amount you owe, what type of debts they are, and other personal financial details. For example, if you are a homeowner, you may have the option to tap into your home’s equity with a home equity line of credit (HELOC) or refinance rather than taking out a personal loan or opening a new credit card.

Most debt consolidation loans are either secured or unsecured. A secured loan is backed by an asset. This could be your home, a car, or other kinds of collateral. Unsecured loans are usually harder to qualify for, especially if you need a larger amount. This is because they are not supported by any kind of collateral, which makes it riskier for lenders to provide them. Unsecured loans also tend to have higher interest rates compared to secured loans, but both will typically come with a fixed interest rate.

Different types of debt consolidation loans

Homeowners will have more options at their disposal, but here are a few of the most popular types of debt consolidation loans for you to consider:

• Personal loans: Most personal loans are a type of unsecured debt consolidation. They can be provided by banks and credit unions, and you will receive a single lump sum to use as you like. Once approved, you will have to add another monthly payment to your budget. However, most personal loans will have a lower interest rate compared to credit card options.

• Cash-out refinance: If you own your home and built enough equity, you can consider using a cash-out refinance. This method of debt consolidation replaces your current mortgage with a new, larger loan. Your new home loan will come with a different rate and term, plus a lump sum of funds at closing that you can use for whatever you want (including debt consolidation).

• Home equity loan: Unlike a cash-out refinance, this method allows you to keep your original mortgage. The home equity loan is secured through the equity in your home, providing a lump sum amount of money that you access all at once, usually with a fixed interest rate. It will need to be repaid over a set period of time, adding a monthly payment to your budget.

• HELOC: HELOCs are a very common method used to consolidate debt. It is a revolving line of credit based on the equity you have in your home. Your lender sets a limit, and you can access the funds if and when you need them during the draw period. Borrowers only need to pay the minimum payment every month until after the draw period is complete. Then, you may be required to pay the balance all at once or you may be allowed to repay it over a specified time period.

HELOC rates are typically variable, but oftentimes they are much lower compared to other debt consolidation methods.

Why choose a HELOC for debt consolidation?

HELOCs are one of the most commonly used loans for debt consolidation. This is because they offer homeowners a flexible way to tap into their equity without affecting their current mortgage or interest rate.

More often than not, HELOC rates are substantially lower in comparison to high-interest credit cards and debt. They also allow you the means to withdraw only as much money as you need, rather than providing a lump sum you have to pay back in its entirety. With a HELOC, you can consolidate your debts into one straightforward payment plan and end up saving thousands in interest over the long run.

When NOT to use a consolidation loan?

It is important to remember that debt consolidation is not the ultimate debt management solution. While it can offer immediate relief for higher interest debts, you must be committed to changing your spending habits and remaining on track with paying off the method you choose for consolidation. You may not want to consider a debt consolidation if the following applies:

1. You have a smaller amount of debt that can be tackled using other methods. (For example, the debt snowball or avalanche approach.) When you apply for a new loan or credit card, a hard credit inquiry will be required and you may see a drop in your credit score. But this can be worth it if it improves your credit in the long run if it helps you pay off debt more efficiently.

2. If your debts amount to a total that exceeds half of your income, then you may want to consider a debt relief program or debt settlement instead. Otherwise, you may end up overwhelmed with paying off your consolidation loan, despite the new payment plan and rate.

Is debt consolidation a good idea?

The purpose of debt consolidation is to simplify your bills and tackle debt with a single payment and lower interest rate. Though it does not erase your debt, it can make your budgeting and financial planning much more straightforward. However, if you end up continuing to use the credit cards you pay off, then you run the risk of increasing your debt amount even more.

It is a good idea to consult with a financial advisor before deciding if debt consolidation is right for you. That way, you can better understand all of your debt management options and move forward with a plan you are confident in.