All About Debt Consolidation


What is debt consolidation?

Taking a new loan or opening a new credit account despite struggling with multiple debt obligations might seem strange. However, this is what debt consolidation is. It is a financial strategy in which multiple financial liabilities are consolidated into a single debt. In other words, debt consolidation is when the borrower takes up new debt to pay off existing debts and consolidates the monthly payments into one. Like regular loans, debt consolidation loans can be secured or unsecured.

KEY TAKEAWAYS

  • Debt consolidation is a financial strategy where the borrower borrows to pay off multiple debts.
  • Consolidation of debt helps to streamline finances into one monthly payment and may reduce interest rates.
  • There are secured and unsecured debt consolidation loans.
  • The strategy helps in managing liabilities efficiently.
  • Debt consolidation can be done with a Personal Loan, Home Equity Loan, balance transfer credit card, etc.
  • Consolidating your debt can help you improve your credit score in the long run.

Debt prepayment vs consolidation vs settlement

Debt repayments can sometimes take several years. It becomes more cumbersome when you have multiple debts and have to pay several monthly payments. However, some financial strategies can help manage your liabilities efficiently. These are debt prepayment, debt consolidation, and debt settlement. Let’s find the difference between the three.

1. Debt prepayment: Debt prepayment refers to a debt settlement where the borrower pays the sum due before the official due date. Prepayment can be done for the entire balance of a debt or partially when the borrowing is large.

2. Debt consolidation: Debt consolidation refers to the strategy of consolidating multiple debts into a single loan. By merging all debts, the borrower compacts multiple monthly payments and interests into one. Generally, debt consolidation loans are either secured or unsecured.

3. Debt settlement: Debt settlement is a financial strategy where the borrower reaches a settlement with the creditors to pay less than the sum owed. Debt settlement is usually carried out when the borrower has a lump sum in hand and wishes to repay the debt at once.

How does Personal Loan for Debt Consolidation work?

A debt consolidation loan is usually a Personal Loan used to pay off all your debt like credit cards and loans. To consolidate your debt, the easiest thing you can do is to apply for a new Personal Loan in the value of all your debt obligations. If the loan is approved, you can pay off your debts faster, after which you can focus on paying off a single debt.

Usually, Personal Loans are unsecured, not backed by collateral and are offered at a higher rate of interest. However, these loans have a lower interest rate than credit cards. So, using a Personal Loan for consolidating credit card debt can be a wise thing to do.

On the other hand, a strong credit score may help you get a lower interest rate on a Personal Loan. But a poor credit score makes the approval difficult. So, you should consider other ways of consolidating your debt which may include a home equity loan, balance transfer credit cards, etc.

Types of debt consolidation

Apart from Personal Loans, there are many other ways to consolidate your debt which are as follows:

1. Home Equity Line of Credit: In a HELOC, you can take a loan using your home as collateral. HELOC is a revolving line of credit like a credit card where you can borrow amounts up to a certain limit anytime. With lower interest rates than Personal Loans or credit cards, you can consolidate your debt at less cost. But defaulting on a HELOC involves the risk of loss of your home. So, timely payments must be ensured.

2. Credit card balance transfer: Credit cards known as balance transfer cards allow you to transfer your credit card balance to a new card at low or no interest for a specific time. However, to qualify for a balance transfer credit card at lower rates of interest, you should have a good credit score. Also, debt consolidation in a new credit card may make you spend more due to your existing cards becoming clear of debt once again.

3. Loans from family or friends: You can also consolidate your debt by borrowing from family or friends. This can be the easiest way as you can avoid the multiple fees and get a favourable interest rate. However, borrowing from family or friends usually involves no terms, which may be riskier for you and the lender.

Advantages of debt consolidation

Debt consolidation makes it easier and faster to pay off multiple debt obligations. Additional advantages of the mechanism are as follows:

1. Streamline finances: Debt consolidation is an excellent way to streamline multiple monthly payments into one. The mechanism helps you handle your debts efficiently as you don’t have to worry about several due dates of your monthly payments.

2. May lower interest rates: Paying for multiple debts includes multiple interest payments. With debt consolidation, you can compact your interest payments into one, which may reduce the overall interest rates on the borrowing.

3. May reduce monthly payments: Consolidating your debt may reduce your overall monthly payment due to the spread of future finances into a new loan with an extended term.

4. Improves credit score: A debt consolidation loan can initially dip your credit score. However, by consolidating your debts, you can be more consistent and punctual in making a single monthly payment. This may help improve your credit score over a period. Debt consolidation to pay off your credit card balances lowers your credit utilisation ratio, which improves your credit score.

Disadvantages of debt consolidation

Debt consolidation surely offers several benefits, but it comes with disadvantages that you cannot ignore. They are as follows:

1. Added costs: A debt consolidation mechanism comes with added costs that may include balance transfer fees, closing costs, annual fees, and origination fees.

2. No solution to financial issues: Consolidating your debt is not a solution to financial issues that lead you to take debts. The mechanism only helps in streamlining your finances. Also, you may spend more due to the illusion that you have paid off your debts.

3. Raises interest over time: With debt consolidation, the interest rate may decrease on the new loan, but the overall interest payments may increase over the entire loan tenure. Also, if your credit score isn’t good enough to qualify for lower interest rates, you may get a new loan with interest rates higher than your previous debts.

Effect of debt consolidation on credit score

Debt consolidation impacts your credit score in both positive and negative ways. The negative impacts on credit score are caused by:

1. Fresh credit application: When you apply for a debt consolidation loan or balance transfer credit card, a hard inquiry is carried out by the lender, which reduces your credit score.

2. New credit account: A new credit account opening also lowers your credit scores temporarily as the lender looks at your credit as a risk.

The positive impacts on credit scores due to debt consolidation are caused by:

1. Low credit utilisation ratio: The credit utilisation ratio is a measure of the available credit you are using. A new debt consolidation loan increases your available credit, which lowers your credit utilisation ratio, positively impacting your credit scores.

2. Improvement in payment history: Timely payments are a crucial factor in deciding your credit scores. So, if you pay for the debt consolidation loan on time, your credit scores will gradually improve.

Example of Debt Consolidation

Let’s understand the concept of debt consolidation with a simple example.

Suppose you have a total debt obligation of ₹7 Lakh that consists of:

  • A two-year loan of ₹3 Lakh at a 15% interest rate.
  • Another loan of ₹4 Lakh at a 12% interest rate.

Suppose the monthly payments on both the loans come to ₹15,000. To consolidate your debt into one monthly payment, you take a new Personal Loan of ₹7 Lakh. Now you have to pay a single monthly payment of ₹10,000 instead of two payments costing ₹15,000. With the new loan, you can also spread your tenure over a longer duration making the EMIs more affordable.

Final words

Management of multiple debt obligations with their due dates, monthly payments and interests can be a difficult task. Paying late for one debt payment can impact your credit score. Thus, debt consolidation can be a smarter way to manage your debts. Debt consolidation can also keep your credit score strong by simplifying your finances. However, before opting for a debt consolidation strategy, evaluate the types and number of your debts. Also, consider the interest, fees and the impact of debt consolidation on your credit score.

Other Words

  • Debt
  • Default Risk

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