Does Debt Consolidation Work for Everyone?

how does debt consolidation work pros and cons

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Have you been told not to put all your eggs in one basket? We often use this expression to caution against the negatives of pulling your assets or investments under one roof. However, when it comes to debt management, putting all your eggs in one basket is not such a bad thing.

Technically, it is not possible to pull in different loans and merge them under one lender.  Since each loan has a separate contract regulated by unique terms (including the loan term, interest rates, and applicable fees) and governed by different laws.

Debt consolidation essentially entails taking up one large loan and using its’ proceeds to pay-off all other smaller debts. It relieves you of the contractual obligation to many lenders leaving you financially committed to only one lender. In other words, you end up with one loan which you have committed to its’ payment terms.

Debt consolidation loans are popular in the US and people use them to merge their credit card balances, regularize overdraft positions, and pay off other smaller loans such as pay-day loans. They are issued by banks, debt consolidation companies, credit unions, and other licensed financial services providers.

Unlike credit cards, personal loans, and mortgages, people turn to debt consolidation loans as a way to help them manage their debts. You could be having challenges repaying your debts or if you frequently miss making payments on time, the loans are often seen as a remedy for personal financial woes.

But, is it a smart way to solve financial distress? How does debt consolidation work? What are the pros and cons of debt consolidation? And how can you make debt consolidation work for you?

How Debt Consolidation Works

As you have read, debt consolidation loans are essentially just another type of loan. There are two main categories of debt consolidation loans, secured and unsecured loans. The secured consolidation loans are often advanced by traditional lenders such as banks or credit unions. They require collateral such as your home equity and often attract lower interest rates. On the other hand, unsecured consolidation loans don’t require collateral. But, they come at higher interest rates.

The purpose of funds is what significantly differentiates debt consolidation loans from other loans. Whereas in consumer loans, mortgages and credit cards, the lender is flexible, in terms of permitting you some leeway on how to expend the funds, in debt consolidation loans, the lender advances the facility on strict conditions for paying off your smaller loans.

A typical loan value ranges from $ 5,000 to about $ 50,000, but some lenders offer loans beyond these limits. Depending on your debts, debt-to-income-ratio, and credit score, a lender will qualify you for a particular amount. Debt consolidation loan terms range between one and five years, and you’ll get an opportunity to confirm the applicable interest rate and other associated fees.

When you apply, each lender employs a unique criterion for considering your application. Some accept low credit scores, while others set a higher credit score threshold before qualification. If your credit score isn’t quite where you would like it to be and you would like to improve it, reach out to Credit Repair and get practical advice and help towards reaching a realistic target score.

Lenders also vary in terms of the maximum debt-to-income ratio permitted. Some go as high as 50 percent while others put a more stringent, lower proportion. Debt-to-income ratio is the fraction of your gross monthly income that is taken up by debts.

After you have finalized the application and the lender has performed their checks. The lender will approve and disburse the loan. However, the funds will not be channeled to your account. Instead, the lender will settle the other debts by wiring the cash directly to the other creditors or issue checks for bank deposit. Thereafter, you will begin servicing the new loan according to the terms set forth in the agreement.

Pros and Cons of Debt Consolidation

You will often hear of the benefits of debt consolidation but seldom about its downsides. Here is a look at the two sides of the coin.

Pros

The most touted benefit of debt consolidation is that it’s an excellent way to simplify debt management. You will no longer need to keep track of several creditors and mark several dates on your calendar for debt repayment. Instead, you’ll have only one lender, one loan, one set of “terms and conditions,” and one date to keep track.

In some cases, debt consolidation loans (especially secured loans) attract lower interest rates than other loans such as credit cards, pay-day loans, and unsecured personal loans. Therefore such a loan would save you cash.

The lender may also grant a longer repayment term giving you more flexibility as you would have smaller monthly installments to pay.  With such flexibility, lower interest rates and ease in management, life becomes easier with a debt consolidation loan. Moreover, if you maintain your repayment amount at the same level as though the rates and terms of payment had not improved you’ll end up clearing your debts much faster.

So, a debt consolidation loan can help you get rid of debt faster.

Cons

Having read about the advantages of debt consolidation, you’ll need to know about its downsides before you dive in.

First, you could end up paying more in interests. Lower interest rate debt consolidation loans are often secured. However, there are unsecured debt consolidation loans. For instance, balance transfer credit cards, which allow you to transfer your balances from other credit cards to one credit card issuer. Such offers typically open with an initial “low-interest rate period” that is often unrealistic to meet but end up driving you into higher interest rate debt. You can read more about balance transfer credit cards and how suitable they are for you in this article.

A second disadvantage is that debt consolidation could hurt your credit score. First, you’ll close several accounts (assuming that you’ve been servicing your loans properly) which will negatively impact your credit utilization. Secondly, your credit history will have only one lender, with a huge balance.  Finally, as you apply for the debt consolidation loan, the lender will have to make a hard inquiry which translates to lowering your overall score.

Secured debt consolidation loans expose you to a higher risk of losing a more valuable asset. For instance, if you take a home equity loan debt consolidation loan, you’ll put your home on the line and it could end up in a forced closure. Whereas maintaining several “smaller loan creditors” wouldn’t have such dire consequences.

A last but crucial disadvantage of taking a debt consolidation loan is that it could fool you back into unhealthy financial habits. As mentioned earlier, debt consolidation loans make life easier. Especially when you get lower interest rates and longer loan term. You’ll have better cash flow and if there’s no behavior change, you may revert to the financial muddle you were trying to escape.

Debt consolidation doesn’t take debt away; it only takes care of the symptoms of poor financial management. If you don’t address the behavior issues, whether it is an income problem or a spending challenge, you’ll end up in a worse financial state.

How to Make Debt Consolidation Work for You

If the disadvantages of debt consolidation scare you, remember, just like a wild stallion, debt consolidation can crush you or you can use it to ride to freedom. Debt consolidation is an excellent way to take away the hassles of tracking multiple debts and keeping up with different terms of payment.

However, most traditional lenders (such as banks and credit unions) set very high standards for qualification. Be that as it may, there are other lenders who are more flexible and can advance a debt consolidation loan even when you have poor credit.

However, before you plunge into a debt consolidation loan, examine if it’s the best fit for you and how you can make it work for you. Here’s how you can do that.

First, seek advice about managing your debts explore the pros and cons of different ways to manage your repayments. Seek advice from qualified, and reputable financial advisors such as Bad Credit Survival Guide on how to improve your financial situation, pay your debts and improve your credit score.

If you settle for a debt consolidation loan, begin by comparing your loan options. Weigh your risk appetite versus the interest cost. That is to say, since secured debt consolidation loans come at friendlier interest rates, but you have to put a more valuable asset at stake, weigh your willingness to risk losing the asset against how much you’ll save in interests. Also, compare the interest costs among same category debt consolidation loans.

Go for the loan that helps you make the most savings. After all, that is how debt consolidation should work for you. Not only should it reduce the hustles of keeping up with multiple creditors but also enable you to make savings.

Before you sign the dotted line, ensure that you make sufficient provisions for repayment on your budget. Remember, now it’s now a single, but significantly larger payment as compared to the several, smaller payments that you handled.

You can also take steps to ensure that you are with the right partner.

Look for reputable lenders who are easy to contact through various channels, with a verifiable address and who come with strong customer backing. Avoid unscrupulous lenders who seek to prey on your needs, hoodwink you into an unfair deal and end up charging immense interest rates and wrecking your financial history. Your best bet is checking out lenders accredited by the National Foundation for Credit Counseling (NFCC) or Financial Counseling Association of America (FCAA). However, we’ve made it easier for you. Below is a list of what we think tops the list.

Top 5 Debt Consolidation Loan Providers

SoFi

SoFi has excellent debt consolidation facility. The loan range is from $ 5,000 to $ 100,000 (one of the highest limits in the country). The loan terms are flexible and you can choose between a fixed and a variable interest rate. In addition, there are no origination fees or pre-payment penalties. But what makes SoFi stand out is that you can opt for an unemployment protection feature. If you lose your job, you can go for a while without making payments and you won’t hurt your credit.

However, SoFi’s loans have a very high credit score threshold and due to the high value and extended terms, may not work well for you if your income is still moderate or low.

Prosper

Prosper is an excellent partner for anyone who went into borrowing almost blindfolded. They advance loans for consolidating all types of loans and have no restrictions on the loan type. Also, there are no prepayment fees and the lender would extend a loan even if your debt-to-income ratio is high.

However, the goodies are often tagged to certain qualification criterion (including credit score) and if you don’t qualify, you could end up paying higher interest rates. Also, the loans are limited to a maximum of $ 40,000 which may be limiting to some individuals and are subject to an origination fee of about 5 percent.

Lending Club

If your credit score is fair to good, Lending Club might just be the place for you to get a debt consolidation loan that works for you. The lender is a reputed peer to peer lender; they accept co-signers, fair to good credit scores and don’t charge any prepayment fees.

However, if your credit score is not so good, you’ll have to pay for it because you’ll be subjected to a higher APR. Also, all loans are subject to an origination fee of between 1 and 6 percent.

Avant

Another lender that accepts fair to good credit score and can take you in even if you have an income of $ 40,000. Debt consolidation products from Avant are flexible on the income requirement and the lenders are known for their fast approvals and disbursements.

However, the lender does not accept co-signers and their interest rates are higher than several other lenders. They also tend to specialize on credit card balances thus are not as flexible for many borrowers.

Peerform

If you have a good to fair credit score, and a high debt-to-income ratio, Peerform could be your partner for a debt consolidation loan. They accept debt-to-income ratio as high as 40 percent and cover loans from as little as $ 1,000 with no prepayment fees.

However, in as much as they offer low amount loans, their higher limit is also dwarfing. They don’t offer loans higher than $ 25,000 and they fix the payment term to three years. Therefore you could end up paying large amounts of interest for small loans. Also, there’s an origination fee of between 1 and 5 percent.

Conclusion, Escaping the Debt Trap

Before you go for a debt consolidation loan, consider your alternatives. A debt consolidation loan is a major financial step and you will need to make significant adjustments on your budget to make it work for you.

You can consider taking up a balance transfer credit card with zero percent APR and reduce your debt as much as possible within the intro-period. Also, you can check out the local credit unions which could offer debt consolidation personal loans at lower interest rates.

Most crucial is that you need to plan for the repayment and budget for it, especially if you’ve previously struggled to keep up with loan repayments, missed some payments or incurred some penalties for late payments. If it is an income challenge, evaluate your options for boosting your income. This article will give you amazing tips on how you can make a quick buck on the side.  If it is a spending challenge, track spending using apps like Personal Capital and identify areas where you’ll need to cut back. This article will give you more insights into how to get rid of debt.

When evaluating lenders, look out for red flags such as overly aggressive sales reps, unrealistic approvals, quick-fix promises, and requirements such as upfront payments It’s best you stick with reputable lenders as on the recommended list.

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