What Is Debt Consolidation, and Why Is It Helpful?

Debt is a big worry lingering in your mind, even if you’re good at ignoring it. Credit card balances, student loans, car payments, and medical bills add up, making you feel stuck with limited options. Consider debt consolidation if you face large balances that will take decades to pay off. Consolidating payments can help you feel more financially organized and less stressed. What is debt consolidation? You’ll want to understand the ins and outs before you jump in. 

What Is Debt Consolidation?

Debt consolidation is the process of rolling multiple debts into a single, larger debt, often with a lower interest rate, a smaller monthly payment, or both. You pay off your smaller loans with the new one. By combining debts into a single, larger loan, you can get more favorable terms, such as a lower interest rate, lower payment, or both. 

Consolidation can streamline payments for student loans, credit card balances, and other debts.

The best way to get out of debt will depend on the amount owed, your ability to repay it, and whether you qualify for a relatively inexpensive loan. Taking out a debt consolidation loan isn’t a quick or easy fix to your current debt load, but it can be a responsible step toward financial freedom. Before you proceed, it’s crucial to evaluate your financial habits, future goals, and current debt load. 

When Should You Consider Consolidating Debt?

Debt consolidation is a way to simplify your financial life. With the possibility of lower interest rates and smaller monthly payments, you will have fewer monthly bills and due dates to worry about.

Debt consolidation may be a good idea if:

  • You Have A Lot of Debt. Consolidation isn’t worth the fees and credit checks needed if your current payments allow you to be debt-free within a year. If you can pay off your debt within 12 months, consider other payoff strategies, like the snowball or avalanche approach
  • Your Credit Has Improved. If your credit score has increased since taking out prior loans, you may qualify for an interest rate lower than your current one. You save on interest over the life of the loan. 
  • You Can Afford to Repay the Loan. Consolidating your debt is only good if you can pay your current monthly debt. You’ll still need to make monthly payments, so you need regular income. Before consolidating, evaluate your budget and develop a plan to get your finances under control. 

Benefits of Debt Consolidation

Debt can seriously threaten your financial security because it keeps you from making the most of your money, so committing to paying down debt comes with many benefits. Still, every person’s financial situation is unique, so it’s best to examine your options and determine if the time is right for you.   

Benefits of debt consolidation include:

  • Eliminates Debt Quicker. Only making minimum payments stretches your repayment timeline. Consolidation allows you to accrue less interest. You can use the extra cash to pay off debt earlier. 
  • Simplifies Your Payments. Combining debt into a single loan reduces the number of payments you need to track and minimizes the chances of missing a payment. You won’t have to worry about multiple bill due dates.
  • Improves Your Credit Score. Applying for a new loan creates a hard credit inquiry, resulting in a temporary dip. But long-term, it can improve your score by reducing your credit utilization percentage. Credit utilization is the ratio of your credit card balances to your credit limits. A lower credit utilization percentage has a positive effect on your credit score. Consolidation can reduce the chances of making a late payment or missing a payment entirely, improving your credit score.    
  • Saves You Money. Interest adds hundreds, even thousands, to your debt. Consolidating your debt can provide access to better interest rates, lowering your monthly payment. Be aware that a longer term allows more interest to accrue.

Let’s look at an example. Say you have multiple credit cards with different interest rates and monthly payments:

  • Credit Card 1: $4,500, 25.00% APR
  • Credit Card 2: $3,500, 19.00% APR
  • Credit Card 3: $2,000, 12.00% APR 

You consolidate balances into a single loan for $10,000 with an 8.49% APR. You budget to pay off the loan in four years. Combining debt, you pay $1,828.92 in interest. By comparison, if you made a 4% monthly minimum payment on your three original cards, you would pay more than $7,397 in interest. It would take you nearly 14 years to ultimately pay off the debt. 

Disadvantages of Debt Consolidation

Consolidation isn’t a cure-all for all your debt problems. Debt consolidation also has downsides to consider. When you take out a new loan, your credit score could suffer a minor hit, affecting whether you qualify for other new loans.

Other disadvantages of debt consolidation include: 

  • Prolonged Timeline. Moving debt to a new loan can sometimes involve extending the loan term. This means you will be in debt longer.
  • Lack of Learning. If overspending and irresponsible money management landed you in debt in the first place, consolidating debt on its own probably won’t move you toward financial wellness.
  • Additional Fees. A new loan may involve origination fees, balance transfer fees, closing costs, and annual fees. When shopping for a lender, understand the loan’s actual cost before signing the dotted line. 

What to Do Before Consolidating Debt

The average credit card user carries a balance of $5,474, and the average student loan debt is $37,574. Pile on auto loans and other debt, and it adds up to a big chunk of change. A large debt load and high annual percentage rates create a cycle that’s difficult to escape. 

If you’re swimming in debt, the one thing you may wish for more than anything else is a chance to clean the slate and start over. Of course, barring a winning lottery ticket, nothing will make that much of a change overnight. But you have opportunities to get your debt under control. 

Consolidating into a single loan will streamline your finances but won’t fix underlying financial challenges. Before consolidating your debt, step back and understand what led you down the path and what changes you need to make to stop the spiral. Debt consolidation without a plan is a temporary solution that may worsen matters in the long run. 

Was it a medical bill, loss of a job, or other temporary hardship that caused you to get behind with charges? If you now have a job or the medical issue is resolved, you solved the source of the debt problem. If, on the other hand, you accumulated debt by overspending on credit cards, debt consolidation may not be the answer just yet.  

Approval for debt consolidation requires applying and meeting the lender’s specific criteria. A low debt-to-income ratio and a good credit score will increase your options and lead to better interest rates.

When you’re committed and ready to consolidate debt, you’re going to want to:

  • Create a Budget. Creating a budget doesn’t automatically solve your money problems, but it will help you gain financial awareness and make more responsible decisions. Once you build a budget, review it monthly to determine if you’re staying on track. Adjust the numbers as your financial situation changes.
  • Learn to Save. When it comes to saving, small changes add up quickly. Look for ways to adjust your habits. Simple changes like cooking at home versus eating out, switching cell phone plans, cutting streaming services, or stopping impulse purchases help you keep more money in your pocket. Look at every decision involving money for ways to save.
  • Compare Offers. Stack offers against each other. Review lender’s APRs, fees, repayment terms, and borrowing limits. These add-ons can make debt consolidation more expensive. Find the lender who can provide you with the best terms, such as lower interest and no prepayment penalties, if you can pay off the loan before the term’s end.
  • Consider Credit Counseling. While consolidating your debt may help you pay it off faster, the loan won’t keep you out of the debt cycle. It’s crucial to figure out what caused you to go into debt in the first place. Credit counseling will help you manage money, debt, and budgeting. A credit counselor can discuss debt repayment strategies to help you choose the best method.

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What Options Are Available for Debt Consolidation?

Now that you know what debt consolidation is, you’ll want to consider your alternatives. The best option depends on your circumstances, credit score, and the amount of money you need to borrow. Loans and other financing options allow access to funds via secured or unsecured debt. The primary difference is the presence or absence of collateral. Which is best depends on the terms and types of your current loans and your financial situation. Let’s examine options to determine what’s best for your needs. 

Secured Loans

You can get a secured loan through a credit union or bank in Oklahoma City. This type of loan requires collateral, such as a car, house, or other investment account, as part of the application process. You pledge the asset in case you’re unable to repay the loan. The lender can seize the asset if you don’t make payments on time.  

Secured loans are easier to qualify for and typically offer lower interest rates and higher loan amounts than unsecured loans. The lender considers your credit score, history, income, and debts. Adding collateral to the application lowers the lender’s risk and gives them more confidence to lend to you. It has a lengthy application process, and secured loans come with a penalty for not repaying.  

Types of secured loan options include a:

  • Personal Loan. The most common way to consolidate debt is through a secured personal loan. A personal loan offers fixed interest rates and repayment terms. The duration of the loan and your credit score determine the interest rate. Once approved, you use the loan to pay off existing debts and make payments on the new loan.
  • Home Equity Line of Credit. If your home has appreciated or you paid a portion of the mortgage, you can use the equity to consolidate your debts through a Home Equity Line of Credit (HELOC). It provides a revolving credit line to consolidate higher-interest-rate debt on other loans. HELOCs offer lower interest rates, and the interest may be tax deductible. 
  • Secured Credit Card. Secured credit cards are like traditional credit cards but require a security deposit. The deposit is the collateral on the account. If you can’t make payments, the lender keeps the deposit. With a secured credit card, the amount you put down in a deposit becomes your credit limit for the card.  

Unsecured Loans 

An unsecured loan doesn’t require collateral. It gives you quicker access to funds through a faster approval process. The lender decides to give a loan based on your credit history. They tend to have higher interest rates and lower qualifying amounts. Unsecured loans have stricter requirements to qualify, which often means you pay a higher interest rate with lower limits.  

Common types of unsecured loans include:

  • Unsecured Personal Loans. With an unsecured loan, you repay a lump sum, plus interest, in monthly installments. You have the best chance of qualifying if your credit score is 690 or higher. Unsecured loans are risky because your credit is affected if you default. 
  • Personal Lines of Credit. A line of credit provides access to a set amount of money for a specified time frame, known as the draw period, when you can withdraw money from the account.  
  • Credit Card Balance Transfers. Unsecured credit cards are the most popular and commonly used form of unsecured credit. Your credit score, credit history, and income are crucial factors. You may decide to consolidate multiple credit card payments on a new card. Many credit cards offer 0% APR on balance transfers. 
  • Student Loan. You can consolidate student loans through federal or private programs. Federal consolidation combines multiple student loans into one. The new loan won’t lower your interest rate but will simplify payments.

Strategizing the Use of Personal Loans 

Debt consolidation can feel like immediate relief but doesn’t eliminate the debt or resolve long-term problems. Before consolidating, evaluate why debt has built up and discover any financial habits that need to be addressed.

Consolidation doesn’t work for everyone. Before you speak to a bank or credit union, you’ll want to determine how much you can afford to put toward getting out of debt. The lender will work backward from there to figure out terms, interest rates, and the total amount borrowed.

Debt consolidation may not be a good option if you struggle to make minimum monthly bill payments. Although it may lower your interest rate, bundling all your debt together could result in a higher monthly payment over a shorter period. Debt consolidation doesn’t work for everyone but can do wonders for many people. 

Critical to understanding debt consolidation and how it can help you is determining the order in which you want to tackle it. Prioritize loans or credit cards with the highest interest. This approach will allow you to tackle your most significant problem first, freeing up extra interest payments for smaller balances.  

How Can TFFCU Help With Debt Consolidation?

Debt consolidation in Oklahoma City can be an excellent way to reset your finances. The ability to eliminate high-interest debt and simplify monthly expenses into one payment for debt servicing can change your financial picture. But everyone’s situation is different. You’ll want to work with an adviser to ensure your unique personal needs are met before making your next move. Contact Focus Federal for help answering the question, “What is debt consolidation?”