How Do Debt Consolidation Loans Work?
If you’re like most people, then you might have a couple (or more) loans that you’re currently paying off at the moment. Paying off more multiple debts at a time is not uncommon. You may have a couple of credit cards and have taken out a loan for a car or home, for example. It’s easy to see how you can get overwhelmed, with different loans from different creditors, for different amounts, due at different times, and miss a payment.
Having a debt consolidation loan might be the answer, reducing the stress of multiple debts and interest rates by simplifying your finances.
What is Debt Consolidation and How does it work?
If you’re struggling to balance your debt repayments, debt consolidation may well be worth considering. In a nutshell, debt consolidation is simply the process of bringing your existing multiple debts together into one single new loan, subject to a single interest rate, with a single regular (usually monthly) repayment. This makes managing your debt situation significantly easier and often you can end up paying less each month than you were paying before, all the while helping you manage your repayments and giving you a clearer picture of your finances.
You typically do this by taking out a new personal loan to repay your other existing debts, and then paying this new loan back over a set term.
Types of debt that can be consolidated
All sorts of debts can be put together into one loan, such as credit card bills; medical bills; car and personal loans; unsecured personal loans (no collateral); and utility bills.
These debts or bills are common and if not managed properly, could put a dent into your expenses before you know it.
Do I need to consolidate my debt?
At the end of the day it’s a matter of preference, but many choose to put all their debt into one loan for a variety of reasons:
- One loan for all: By far the number one reason people consider debt consolidation is because it’s all been put together into one convenient bill.
- A simplified repayment plan: No more forgetting payment dates – consolidating your debt means you will remember one date (usually monthly) to pay it all off. If you want to manage your budget or cash flow better, a consolidated debt is the solution.
- Potentially lower interest rate overall: Imagine having different interest rates for various debts. Let’s say, for Debt A there’s an interest rate of 3%; Debt B has 2.25%; and Debt C has an interest rate of 3.33%. With debt consolidation, the new interest rate might be set at just 2.75% for all 3. In the long run, you will be paying less interest and will be saving money from it in the process.
- An end in sight: Paying off debt can feel like it’s never ending, but the truth is, with a debt consolidation loan, there is a light at the end of the tunnel. All debts into one loan means they will all be paid off at the same time. Which means you can be on your way to reaching your other financial goals.
The advantages and drawbacks
Like most things, debt consolidation has its pros and cons to consider:
- Better credit card control: Now that you’re just paying off one loan, you’ll have better control over the use of your credit card. You may choose to cut it up (to prevent future unnecessary spending) or ask the bank to lower the credit limit.
- Budgeting made easier: Because there’s only one loan, setting up a repayment plan is easy – you’ll have a single fixed time frame of when you’ll be debt free allowing you to budget more easily and start saving.
- One loan for all: By far the most obvious advantage of getting a consolidated loan is that you only need to think about one loan.
- One set of fees and charges: Often loans come with annual fees and charges. Having just the one loan means you can reduce the overall amount of annual fees and charges you need to pay.
- No more missed payments: Unlike before when you had several bills to pay with different due dates, now all you have is one payment each month, making it far easier to manage and much harder to forget.
- No more annoying calls from creditors: Lenders enlist the help of debt collectors to help collect payments from people who haven’t been paying up or who have a history of paying late. When you consolidate your debts, expect any calls from creditors to stop.
- Fix bad credit and avoid bankruptcy: As you continue to make your repayments on time and in full, demonstrating good repayment habits and avoiding defaults through late payments, your credit score should improve. It’ll be easier to avoid getting further into debt or even bankruptcy by making sure your income and expenses match or align together. Never spend more than you earn, and always live within your means.
- Exit fees: Some banks or lenders might have exit fees if you decide to withdraw your loan from them. Ask first and see how much it will cost. Withdrawing it might be expensive.
- Taxes: Taxes and other fees may apply if you decide to use your home loan (for example) to consolidate other debts.
Is debt consolidation right for me?
While it may sound like an easy and quick way to pay off debts, there are a number of things you have to think about first before you want to consolidate your loans:
1. Is this what’s best for me now financially?
Can you afford to pay off a single loan versus paying off small ones with different interest rates?
2. Am I saving money in the long run?
You should be able to save more money by paying off a single debt with lower interest rates.
3. Are there any fees or charges?
Sometimes there are exit fees you have no idea about, or because of your bad credit history, you may be paying additional fees and charges. You need to be aware of these to avoid shelling out more than you bargained for.
4. Don’t ignore the fine print.
Don’t be afraid to ask questions. If any part of the agreement or contract is unclear to you, make sure to clarify anything first before signing on the dotted line.
Steps before consolidating your debts
Make a list of your debt. Doing so will make it clearer to you and help you understand just how much you are taking out of your monthly budget, how long it will take before it’s all paid, and to whom. This visualisation exercise helps keep things in perspective. If you’re not sure, get a copy of your credit report to check the details of what you owe.
Compare and contrast. Check out different loan payment schemes and compare which debt consolidation plan will work best for you and your wallet.
Calculate, calculate, calculate. Check how much you would be shelling out with this new loan, its interest rate, and decide if you can do it.
Apply for that loan. When you have chosen a plan that you feel comfortable with, apply for that loan, and wait for your application to be approved. Ideally, a lender will be able to help you manage your debt better by offering a payment plan that is realistic and manageable.
Never miss a payment. Make it a point to never miss your due date because doing so usually means additional charges will be added to your bill.
Get the most out of your consolidated debt
Now that you have one loan to think about compared to the numerous ones before, you can make easy financial goals between now and the end date of your loan payment.
Keep track of your spending.
List down things you always spend on, such as utilities, rent, and other such expenses. Next, list down things you do or buy for enjoyment. Finally, see how much you can still save up. Stacking up your “money out” to your income will help you pinpoint where you can make doable changes and stick to them.
Let people know of your plans.
Letting others know of your financial goals is helpful as they can be supportive of your actions. They can also be considerate when they’re making plans, for example, so you won’t be forced to do something that may hurt your financial goals.
Fun doesn’t have to be expensive.
That usual wine and dine with friends every Saturday night can be turned into a fun game night at your place instead. Be creative about what you can do with your money. This is why it’s important for others to know about your situation. They might learn a thing or two about debt consolidation through you, too!
Watch your progress.
When you see yourself inching closer to the end of paying off your debt, it will feel good. Don’t forget to reward yourself every once in a while, for sticking to the plan and never wavering.
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