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What Is Debt Consolidation and How Does it Work?


Debt consolidation refers to the process of taking out new credit to pay off existing debts. Debt consolidation can potentially save you money on your monthly payments. If your credit score has improved since you took out the previous loan, you may be able to find a lower-interest option. Debt consolidation has the added bonus of transferring all of your current loans into one monthly payment. Here, we’ll explain the debt consolidation process and how it works so you can decide if it might be right for you. 

What Is Debt Consolidation?

Debt consolidation is when a borrower takes out new credit in order to pay off their other previous debts. This can include all forms of credit from payday loans, credit card debt, auto loans, student loans, installment loans and other personal loans like mortgages.

Debt consolidation enables individuals to move all of their existing debts into one, larger form of debt essentially. By doing so, it can help reduce interest costs long-term and help borrowers repay their loans quicker as moving debt into one single monthly payment is easier to manage.

How Does Debt Consolidation Work?

To consolidate their debt, a borrower will usually apply for a personal loan through their bank or another lender. If this is a specified debt consolidation loan, the lender may directly pay off the borrower’s other debts. Alternatively, the borrower will use this money to pay off any outstanding credit they may currently have.

Debt consolidation works to help people reduce their debts into a more manageable method. Having several forms of debt can be stressful, so combining or or merging debts can help people become debt-free quicker.

Why Do People Use Debt Consolidation?

People use debt consolidation to make it easier to manage their finances. Once the borrower’s previous debts are paid off, they will only need to make a single payment each month on the new loan. This helps the borrower keep on top of debt and streamline repayments. Additionally, debt consolidation lowers the amount a borrower pays each month. However, the loan period is extended. 

What Are The Different Types of Debt Consolidation?

Generally, there are two types of debt consolidation loans: secured and unsecured loans. Secured loans require borrowers to pledge an asset, like a house or a car, in case they cannot afford to repay the loan. Unsecured loans, meanwhile, do not require collateral – yet, these may be considered riskier by lenders.

There are several types of debt consolidation that might suit your financial needs, which you can find out specifically about below:  

Debt Consolidation Loan

Debt consolidation loans are a kind of personal loan that can be borrowed from traditional banks and credit unions. There are also numerous specialized debt consolidation online lenders. The loan is used to lower interest rates and streamline debt payments.

If you are looking to get a debt consolidation loan, you should first compare your options. Shop around for the best available option, taking into account loan terms, fees, and interest rates. Using online lenders may help give you an idea of what you qualify for. Online lenders perform soft credit checks to determine your loan offer. Getting a credit check should be your first step in finding a debt consolidation loan. 

Credit Card Balance Transfer

A credit card balance transfer is when a borrower takes out a new credit card and transfers all of their existing balances to it. This works best using a credit card with a low introductory interest rate. The result is a single monthly payment to remember, which covers all pre-existing credit card debt. This can reduce monthly payments and even the overall cost of the debt. If you qualify for it, you may be able to find a card with a 0% interest rate. 

If you are thinking about transferring your credit card balances to a new card, first consider the options available. Check interest rates, relevant transfer fees, any transfer deadlines, and the consequences of being late on repayments.

Student Loan Consolidation

Another popular type of debt consolidation loan is student loan consolidation. Millions of Americans attend college each year, with many falling into debt.

Student loan consolidation is when you combine multiple federal student loans into a single, government-backed loan. This works to lower and simplify monthly repayments. Graduates considering student loan consolidation should look into borrower protections that are available to them, such as Public Service Loan Forgiveness. 

Home Equity Loan

Consolidating debt with a home equity loan is the process of taking out a loan that uses the borrower’s equity in their home as collateral. The money can then be used to pay off existing debts and the borrower makes one monthly home equity payment. Because their home collateralizes the loan, it is likely to qualify for a far lower interest rate than available with a debt consolidation loan.

Cash-out Mortgage Refinance

Cash-out mortgage refinancing is an option in which the borrower refinances a mortgage for more than the loan’s outstanding balance. This allows the borrower to access the difference in cash and use it to repay other debts. As a result, all debt payments are tied into a single charge with the mortgage. And, because the home is used as collateral, the interest rate is likely much lower than on the original debts.

What Are the Pros and Cons to Debt Consolidation?

If you are considering consolidating your debts, you may be wondering whether it is right for you. Below, we have compiled a short list of pros and cons to debt consolidation loans:

The Pros to Debt Consolidation Loans

  • Lower Interest Rates: Some debt consolidation loans have lower interest rates, which can help borrowers accrue less debt over time and become debt-free quicker. This also means you can free up some spare cash.
  • Credit Improvement: Consolidating debt into one single monthly payment can make debt repayments easier to manage. Consequently, you can begin to improve your credit score and mean you can borrow loans more easily in the future.
  • Easy to Manage: Debt consolidation ultimately means borrowers will be able to manage all of their ongoing debts more easily. This could also mean you become debt-free sooner rather than later!

The Cons to Debt Consolidation Loans

  • Collateral: Many secured debt consolidation loans will require you to pledge an asset. If you cannot afford to repay the debt then you may risk having your house or car repossessed.
  • Longer Repayment Period: Depending on your personal financial circumstances, you may end up repaying your debt over a longer period of time.

There are many advantages and potential drawbacks to consider before borrowing a debt consolidation loan. Use an online debt consolidation loan to find out more if you can afford to use a debt consolidation loan.