How Debt Consolidation Works: Is It Worth It?
Most people have seen the advertisements for debt consolidation. Often, they claim you can easily lower your debt payments, reduce your interest rates, and eliminate debts, but how they work can seem a bit mysterious. And, the larger question regarding whether it is worth the effort often looms overhead. To help answer the questions you may have, here’s what you need to know.
How Debt Consolidation Works
At its core, debt consolidation involves obtaining a new financial product, typically a loan, and using the provided funds to pay off your other debts. Then, you simply repay that single loan until it is paid in full.
The appeal lies in being able to have all of your obligations represented by one monthly payment and calculated with a single interest rate. Typically, this is easier to remember and manage, from an oversight standpoint, because you are dealing with one creditor and one payment amount.
Often, people who are considering debt consolidation have numerous debts, making tracking the payment date, varying interest rates, and payment amounts somewhat challenging. So, debt consolidation allows you to remove some of the administrative burdens.
Is Debt Consolidation Worth It?
Whether debt consolidation is a smart move depends on your unique situation. Since it involves obtaining a new financial product, like the above-mentioned loan, your credit score plays a factor in whether you’ll be approved, the total amount you can borrow, as well as the associated interest rate. The payment terms, most notably the length of your loan, is also a consideration.
Additionally, some debt consolidation products require you to put up collateral. For example, you may have the pledge the value of your home to back the loan. This means, if you default, your home would be at risk of being seized.
Further, many debt consolidation products come with a variety of fees that can increase the total cost of the financial product. And, depending on the length of repayment, you could end up paying more and making payments longer than you would have otherwise.
Debt consolidation may also impact your credit score, and it is often in a negative way. If you close your old accounts once they are paid off, the average age of your accounts decreases on your credit score. Plus, you’ll have a new debt added, impacting the average age even more. The other thing to consider is the debt solution you take on. Debt settlement is often promoted as debt consolidation and it has a negative impact on your credit score. However, depending on your situation this still may be the best solution for you as it can put you in a better financial situation which also allows you to start and repair your credit worthiness - learn more about this debt options here.
To make debt consolidation worth it, you need to find a financial product that offers you a lower cost option than what you currently have to manage. Typically, this involves needing to secure a significantly lower interest rate, no unnecessary fees or prepayment penalties, and the shortest repayment terms you can reasonably handle.
You’ll need to calculate the total cost of the switch to a debt consolidation product and see if it would actually save you money in the long run, as well as if you can manage the potential damage to your credit score. Ideally, you want to review the lender's product offering to see what the possible interest rate range is, and don’t assume you will get the lowest rate listed unless you have outstanding credit. Then, run the numbers through a free loan calculator (readily available online) and see if making the switch makes sense, after considering any additional costs and fees.
If the cost and total interest paid turns out to be less, then debt consolidation might be a smart move. If not, then it is better to work with what you have right now. Learn more about specific debt relief options here. Get the ins and outs of different programs and the type of situations they are good for.
