Benefits of Debt Consolidation
It’s all too easy to get yourself caught under a heavy load of high-interest debt. If your monthly debt payments have become unmanageable, one way to reduce them is with a debt consolidation loan.
Why it’s a good idea
The principle of a consolidation loan is simple. You take out a new loan at a lower rate than your existing debts, which may carry higher rates often charged by credit card companies and retailers. Then you use that money to pay off your existing accounts, leaving you with one monthly payment instead of several. And since the new loan is at a lower rate, your new payment will be lower than the combined total of your old payments. That means you can pay off your debt sooner.
An example of how it works:
You have a balance of $5,000 on your bank credit card at 18.9 percent interest.
Monthly payment = $100
You owe $4,000 on a store credit card that charges 17.5 percent.
Monthly payment = $80
You have $11,632 left on a $15,000 car loan at 6.97 percent.
Monthly payment = $359
Your total debt (not including your mortgage) = $20,632
Total monthly debt payments = $539.
At that payment level, your debt is not going down very fast. To ease this burden:
You take a 60-month home equity loan for $20,632 at 7 percent.
New monthly payment = $409
You use this new loan to pay off your other creditors. With the significantly lower interest rate, your new monthly payment is $130 less than your old one. As well, your debt will be paid off in five years, and you’ll pay a total of $3,880 in interest. That’s $5,541 less than you would have paid with your original debts! View our debt consolidation calculator to help you calculate your estimated savings from consolidating your debt.
Using a home equity loan or line of credit
One common type of debt consolidation loan is a home equity loan or line of credit. Since the loan is secured by the equity you have in your home, the lender is able to give you a lower interest rate. The amount you can borrow depends on how much equity you have; lenders will typically loan you an amount equal to 80 percent of your equity.
The interest on a home equity loan may be tax-deductible, effectively reducing the cost of the loan (check with a tax adviser about your particular situation). However, remember that home equity loans use your house as security, and if you fail to repay them, your home could be in jeopardy.
Using a personal loan
Lenders also offer personal loans to consolidate your debt. However, with this type of loan it may be more difficult to get an interest rate low enough to improve your situation, especially if your credit rating is considered risky. If it is an unsecured loan, the interest rate can be much higher than with a home equity loan. One way to secure better terms is to have a family member or other responsible person co-sign with you, guaranteeing repayment.
Other ways to reduce your debt
You can also transfer your credit card balances to a card with a lower interest rate. Or, if you have serious credit problems, you can resort to credit counseling, and have a debt manager negotiate lower rates with your creditors. However, using a debt manager may affect your credit rating, and it’s important to choose carefully: some debt managers charge high fees and use unscrupulous practices.
Look carefully before you sign any loan. In order to help reduce your debt, a debt consolidation loan should have an interest rate that is significantly lower than what you’re paying now. Also, be careful it doesn’t just lower your payments by stretching them out over a much longer period as this can significantly increase the total amount of interest you pay. And check for extra fees and commissions, plus added costs such as unnecessary credit insurance.
Change your spending habits
It’s important to remember that a debt consolidation loan works only if you stop creating new debt. Otherwise, you’ll end up back in the same situation. It can help get you back on the road to fiscal health. But it’s only effective if you choose the right loan, and change your spending habits to avoid running up new debt.