How Does Debt Consolidation Work?

Americans average about four credit cards per person with an average balance of about $8,000. Add in a car payment and an outstanding medical bill, remembering to make all those monthly payments or struggling to meet the minimum payment are the main reasons people look at debt consolidation. Instead of making multiple monthly payments, consumers consolidate their debts into one monthly payment, often at a lower interest rate and monthly payment.

What Is Debt Consolidation?

Debt consolidation means applying for a new, lower-interest loan to pay off existing debts. Once the existing debts are paid, the borrower only needs to make a single payment for the new loan. For example, a consumer has $8,100 in debts spread over the following:

  • Credit Card 1. $1,000
  • Credit Card 2. $2,500
  • Personal Loan $4,000
  • Credit Card 3. $600

With debt consolidation, the consumer takes out a loan for $8,100, pays off the four debts completely, and makes a single monthly payment to repay the new loan. Some lenders will give the borrower the funds, but others may insist on paying the various debts directly. Debt Consolidation can be achieved through credit card balance transfers, Personal Loans, Home Equity Loans, or Home Equity Lines of Credit. The most suitable option depends on the individual.

Benefits of Debt Consolidation

Consolidating debts has many benefits to help consumers take control of their finances, such as:

  • Managing debt is easier with a single monthly payment.
  • The overall interest rate may be reduced depending on the consolidation option.
  • Monthly payment may be lower if the loan term is extended.
  • Fixed payments can result in a faster payoff, especially if the consolidated debts are from credit cards.
  • Debt consolidation may improve credit scores.

However, debt consolidation is not for everyone.

The Reality of Debt Consolidation

Most people have financial struggles at some point. Whether it’s a job loss or medical expenses, debts can accrue that become overwhelming. In such circumstances, debt consolidation can make a significant difference. However, consolidating debts won’t help if borrowers lack financial management skills because they are likely to return to their bad habits.

Some lenders may pay the outstanding debts directly, eliminating the possibility of the borrower using the loan for something other than debt repayment. Borrowers can ask that the lender pay the debts directly, which is an excellent option for borrowers wanting to change poor financial management skills.

Debt consolidation does not eliminate debt. The repayment period may be longer, which could increase the overall cost. The loan may require collateral such as home equity-based loans. It’s important for consumers to look at available solutions to determine if debt consolidation is right for their circumstances.

What Debt Consolidation Solutions are Available?

Borrowers can choose from a range of debt consolidation options such as:

Personal Loan

Personal Loans are unsecured loans that do not require collateral. Their interest rates tend to be higher than secured loans (such as Home Equity Loans and HELOCs) but often are lower than the rates on existing debts. They can result in lower interest rates, fewer monthly payments, and improved repayment terms.

Home Equity Loan

Homeowners may have equity in their homes which can be used for debt consolidation. A Home Equity Loan is paid in a lump sum which the borrower can use to pay off existing debts. Once the funds are dispersed, the borrower must make monthly payments on the loan amount.

The equity in the home determines the amount of the loan. Equity is the difference between what is owed on the home mortgage and the property’s market value. Since Home Equity Loans are secured, the loan interest rates and terms are usually more favorable than those for a Personal Loan.

Home Equity Line of Credit

A Home Equity Line of Credit or HELOC uses the equity in a borrower’s home to secure a revolving line of credit. It can be used to cover large expenses or consolidate debt. With a HELOC, homeowners are using the available equity in their home as collateral for the line of credit. As the borrowed amount is repaid, the available credit is increased until the entire amount is repaid and the credit line returns to its original amount. Unlike a Home Equity Loan, the HELOC rate may fluctuate over time.

Cash-Out Mortgage Refinance

Homeowners can refinance their mortgage for more than the balance of the original loan. The borrower can then use the cash to pay off existing debt and the cash received becomes part of the mortgage. The cash-out option usually means a lower interest rate and a single mortgage payment.

How to Choose The Right Debt Consolidation Solution

Choosing the most suitable debt consolidation solution depends on the borrower’s needs and their personal finances. Whether considering applying for a Personal Loan, applying for a HELOC or applying for a Home Equity Loan, consumers should speak with knowledgeable individuals such as those at their local credit union.

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