Debt consolidation allows an individual to consolidate or combine various different types of debts such as a personal loan or credit card debt into a single loan. The benefit of consolidating the debts is it may allow the debtor to extend the repayment period and lower the interest payments, allowing the debtor more time to repay the debts.
Who can benefit from debt consolidation?
Debt consolidation can be a good idea for those debtors who are very disciplined, who have sufficient equity in property and who have good credit. Debtors who do not have good credit, who are close to bankruptcy, or who do not have the discipline to make debt payments may not benefit from consolidation. For example, if you continue to increase your debt while you are attempting to pay a consolidated loan, you will not benefit from the consolidation.
Why debt consolidation can be dangerous
Debt consolidation can also be dangerous. For example, if you have decided to consolidate credit card debts from six different credit cards and repay the debt with a home equity loan you have taken unsecured debts (the credit cards) and secured the debt repayment with your home as collateral.
If you fail to repay the home equity loan the creditor can put a lien against your home. Additionally, if you have to eventually file for bankruptcy, the unsecured debt might have been discharged; the secured debt would not.
Debt consolidation may also lower the interest rate on the loan but extend the terms of the loan. In some cases the extension could be so long that you simply stay in debt and end up paying the lender more.
For example, let’s say you have a two-year loan for $10,000 at 12%, and a four-year loan for $20,000 at 10%. Your monthly payment on the $10,000 loan is $517 and $583 on the $20,000 loan. What if you could lower your interest rate for both loans to 9% and make your monthly payment $640 for both loans? But what if I told you it would now take you six years to pay off both loans? Unfortunately, you will end up paying $46,080 to pay off the new loan instead of $40,392 for the original loans. You received a lower interest rate, but the length of the loan repayment period negated the savings. (Example provided by Dave Ramsey at daveramsey.com)
Debt consolidation on your own
Debt consolidation is actually something you can do on your own. Although it might seem nice to get a big loan and pay everything off and only make one loan payment a month, you don’t have to hire an institution to do this for you.
The first step is to create a realistic budget. List all of your expenses and income each month. This might require keeping daily tabs on what you spend. Next, decide if you want to pay the credit cards with the highest interest rates- which can save you money- or if you would rather pay the ones with the lowest balances- this will give you a sense of accomplishment and incentives to keep going. You can also set up an automatic payment plan each month with your bank, but be sure to pay more than the minimums.
Finally, stop charging on your credit cards. It won’t do any good to take the steps above if you don’t change your purchasing habits.
What’s the bottom line? Debt consolidation can be a good idea for some debtors. For others, it’s a disaster. Generally, there are other alternatives which could be better for most debtors.
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