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Debt Consolidation is a Path to Financial Freedom

Carl Andrews

Financial Advisor
Updated: 12/2017

Debt has a tendency to drag people’s lives down. When outstanding obligations are owed, the ability to maintain any level of financial independence becomes incredibly difficult. High rates of interest do borrowers no favors. As monthly payments are made, significant amounts of the funds go to pay interest. Paying more than the monthly minimum aggravates this outcome. Many cannot, however, pay more than the monthly minimum because they simply owe too much to too many lenders. A person with a number of “maxed out” credit cards is going to find paying off debt to be extremely problematic.

An often-mentioned solution is to procure a debt consolidation arrangement. A bit of confusion arises regarding how debt consolidation works. A better understanding of the process is sure to lead to a preferred and more agreeable outcome.

The Concept of Debt Consolidation

Debt consolidation refers to the combining of various debts under one single loan. Credit cards and other unsecured debts are the ones commonly paid off with a new loan. Consolidation loans deliver a number of helpful benefits to those who are otherwise struggling with their finances. Lower interest rates are the most appealing. The less interest on a loan, the quicker the loan is to pay off.

Lower monthly payments are absolutely appreciated by those who are stuck paying hundreds upon hundreds of dollars per month in the form of minimum payments. As previously mentioned, paying extra is necessary to quickly eliminate a loan. Paying an extra $100 on a debt consolidation loan is positively more beneficial than paying an extra $300 across several loans and never addressing the principle.

The basic concept of a debt consolidation loan is easy to grasp. What may be surprising to some is there are different forms this type of loan can take.

Two Basic Forms of Debt Consolidation Loans

Debt consolidation loans come in two varieties: unsecured and secured. Unsecured loans are what most seek out first.

Unsecured loans are, ironically, the category of loans that get people into serious debt problems in the first place. An unsecured loan is a personal loan issued based on someone’s previous credit history, income, and financial situation. No collateral is required to access one of these loans, but just like in any other kind of loan, this will take its toll on your credit rating which may be ruined by mounting debt. However, creditors would have higher standards on whether or not they would grant you the loan. Those unable to acquire a personal loan should look towards secured loan options.

Secured loans are the ones backed by some form of collateral. Defaults on the loan mean liens against or seizures of the collateral are possible outcomes. A positive side to these loans is, in addition to their being more easily approved, the interest rates are lower than unsecured ones. Moreover, higher amounts can be taken out when a loan is backed by collateral. Of course, the utmost serious is required to pay back such a loan due to consequences associated with default. Interestingly, lenders have a positive outlook on those who take out consolidation loans.

Positive Impressions of the Borrowers

People who opt to take out a consolidation loan are becoming very serious about getting their finances in order. Granted, there are those who make the drastic mistake of running up new debt on top of the consolidation loan amount. Not every borrower learns his or her lesson. Based on averages, it seems most people do. A gallant effort is made to pay off debt. Usually, three to five years is all it takes to do so.

The Search for a Lender

Finding a lender capable of issuing a debt consolidation loan should not be too difficult. All banks and credit unions are in the business of issuing loans. Debt consolidation loans are among them. Simply inquire with the loan department of a financial institution to start the application process.

Moving as quickly as possible with the process is absolutely recommended. The quicker things move, the faster all those high-interest loans end up eliminated.

What are the advantages of consolidating your debt?

The calls will stop coming

If you have a total of $10,000 in loans or have multiple debts, you would find debt consolidation to be very beneficial as well. People burdened with high-interest rates or have high monthly payments who are unable to renegotiate a lower rate interest rate on their loans would be able to get a more manageable payment plan with lower interests through a debt consolidation agency.

For any of the reasons stated above, you may be used to collection agencies having your phone ringing every so often or receiving letters from them. That will stop once you have consolidated your debt with a qualified agency because it assumed that for as far as the creditors are concerned, your debts have been paid off.

Tax breaks

This is not applicable to unsecured debt consolidation loans like personal loans. However, if your consolidation loan is secured, you might be able to qualify for tax deduction most especially when home equity is involved. Here, your loan interest payments would be deducted from your taxable income.

Boosting your credit score

At the beginning of consolidating your debts, you would see a slight dip in your credit rating because newer and bigger loans are deemed a risk by lenders. Now, because the very idea behind debt consolidation is rolling up all your debts into one, you have a sizable and new debt.

However, because the term payments are relatively more manageable and the interest rates are much lower, you would be able to pay them much quicker. So, as you continue to make the payments on time, you would see your rating increase up until you are completely debt-free.

What is the best way to consolidate your debts?

When your lender does not decide which of your creditors are paid first, the best practice is to pay off high-interest debts first so the interest does not compound any further. However, you may also choose even the debt with the lowest interest if it is causing you stress or strained family relations, which is usually the case when you have a cosigner. The process of paying your creditors in order of a set priority determined by your or your lender is called the waterfall payment process.

The ‘dangers’ of consolidating your debt and how to conquer them

Looking at the possibility of losing assets

This only holds true for secured consolidation loans like home equity loan (HEL) and home equity line of credit (HELOC). As you already know, it is much easier to get a secured consolidation loan, although it means putting up assets as a collateral.

Solution:

If you are not committed to making regular term payments, you may risk losing collateral to the lender. So, by simply cut costs and make sure to meet the payment deadlines, you won’t have any problem.

Getting longer loan terms

Just to be clear, this is not true for all debt consolidation agencies. However, there are some that rely on shady practices to deepen their pockets. Longer loan terms are not necessarily bad. However, some agencies set a payment schedule substantially longer than the average of your previous debts. If this is the case, you may end paying the same amount or even more than what you would have if you did not consolidate your debt.

Solution:

There is nothing more powerful than knowledge. Even if what you are supposed to pay every month is lower than what you would have if you did not have your debts consolidated, still look at the numbers. Compute how much you would save, if at all. No matter how much you trust the agency, do this just to be safe.

Getting a lower credit score

Your credit score is affected by your payment history on different loans, and the longer and the more consistent your payments are, the better. So replacing these debts with a bigger and newer one will temporarily have a modest impact on your credit rating. Moreover, if you would close all your credit accounts to avoid spending even more, your debt to credit ratio can also have a dent in your credit score.

Solution:

You can’t do anything about the temporary decrease in your credit score aside from settling your term payments on time. This will be recorded in your payment history, thus resulting in a rise in your credit score. Also, instead of just closing your credit accounts, you can keep them open so you can improve your debt to credit ratio.

Paying a lot of money for debt consolidation services

A few bad agencies are involving themselves in unfair and unacceptable practices like charging customers to provide information that you would be given by legitimate agencies for no charge. Others charge hefty initial fees and even monthly fees for you to avail of their services. The point of consolidating your debt is to control your financial health and to make the monthly payments lower. By falling for these sketchy practices, it would be close to impossible for you to save at all.

Solution:

Consultations are always free so if any place you go to asks for payment, think twice before letting them consolidate your debt for you. There are many debt consolidation agencies like ours who you can contact to get free financial advice.

You might end up losing special benefits

Some loans like student loans come with special benefits like rebates and discounts on the interest rate. By rolling it without your other debts, you lose these benefits.

Solution:

If you want to consolidate your student loan with your other debts, look at the numbers again and see how this would affect your payments. Compare how much you’d pay if you would not consolidate it. By weighing the costs and the benefits, you get the best decision.

What are the alternatives to debt consolidation?

Paying your debts on your own

Unless you feel the amount of debt you currently have is manageable, you can rid yourself of any hassle and just pay them on your own. You can make a payment plan of sorts, compare your income flow to your debts, and pay your debts off one at a time.

This is a good option if you just have a few credit accounts that you consistently use or if your debts do not pile up because you pay them on time.

Debt management

If you cannot qualify for a debt consolidation product you want because of a low credit score or of simply having too many debts from different accounts, you can go for debt management. Here, you would have to cut your credit card lines to prevent yourself from adding to your outstanding balances.

Debt settlement

Debt settlement is negotiating to pay only a fraction of your outstanding debt balance to your creditors instead of letting the interest compound over time. This means that you have to have a substantial amount on hand, depending on the number both parties would agree on. If you prefer, you can do this on your own or through a company.

Is debt consolidation right for you?

Debt consolidation is a great way to take back charge of your life and of your finances, but still have credit cards in case of emergencies. If you can exercise control and can stick to the plan, this would work. In just a few years, your credit rating would spike and you would be completely debt-free.

You can achieve long-term financial freedom with debt consolidation because it does not prevent you from reverting back to your old habits. Theoretically, you can still bury yourself in piles of debt. But given the guidance and advice provided by your counselor, you hopefully would do much better.

Restraint on expenses and smart financial choices that you will have inculcated in a few years can guarantee that you would not fall into the same traps again.