Moneymagpie Team 11th Mar 2024No Comments
Reading Time: 4 minutes
To consolidate your debt is to organise and move your debt, and to arrange better terms for the repayments. Specifically, this means you will take out a new loan– whether that’s by personal loan, mortgage, or balance transfer credit card– and use that to pay off your existing debt. By doing this, you can combine multiple debts with a single lender, and you are often offered lower interest rates, or no-interest periods by your new lender.
But whether this is right for you will be reliant on your personal situation, so our guide will help you make an informed decision.
- Does Debt Consolidation Work?
- A Debt Consolidation Example
- Types of Debt Consolidation Loans
- Credit Cards
- How to Qualify for Debt Consolidation
- Risks of Debt Consolidation
Does Debt Consolidation Work?
Though it might seem counterintuitive, refreshing your debt by taking out a new credit card or loan can be extremely beneficial. Lenders prefer your interest payments are made to them, not to their competitors, so they are happy to help you move your debt over their bank, and to offer better rates. And while this won’t reduce your debts, it will organise your debts into one place and slow their growth.
A Debt Consolidation Example
Say you have three cards and a total of $20,000 owed, and compounding at 22.99% p.a.. To eliminate your debt, you would have to pay $1,047 per month for two years. During these two years, you would have had to pay an additional $4,603 in interest.
But if you consolidated these debts at a reduced rate, such as 11% p.a., you would only need to pay $932 per month for two years. In this case, the interest that you paid would only be $2,157.
And, if you can manage to pay your debt within a shorter period, you may be able to accrue no interest. This can be done with a balance transfer credit card that offers an introductory period. These introductory periods range from six to eighteen months, but there is a catch– if you don’t pay off your debt during this period, the interest rate will shoot up to over 20% p.a.
Types of Debt Consolidation Loans
There are secured loans, and unsecured loans. All repayment methods fall into one of these categories. Unsecured loans are generally smaller, and do not need assets put up for collateral, and secured loans are bigger and require collateral.
If you have the assets available, a secured loan is the better option. They offer better rates, lower repayments, and are less subject to change. The catch is that if you cannot make your repayments on time, you may lose the asset that you have put up as security. Examples include car loans, home loans and share-secured loans.
If you do not have assets to use for security, you can apply for an unsecured loan, which still offers far lower interest rates than a credit card. The catch here is that the requirements are harder to meet. You need both a reliable, considerable income, and a high credit score. These requirements go up as the price requested goes up. Examples include payday loans, student loans, and personal loans.
Credit Cards
A new credit card with a lower interest rate is often the easiest loan for you to be approved for, but their interest rates will also be higher than a personal loan from a bank. Credit cards also do not need to be secured with assets, and only need proof of income and a reliable credit score.
When you select a credit card for a balance transfer, you should choose a card specially designed for this. They offer an interest-free period, or lower interest rates. If you expect to pay off this debt quickly, they can be the best method for debt consolidation, but it should be noted that some cards charge a fee upfront for the initial transfer of debt.
How to Qualify for Debt Consolidation
If you want to show a creditor that you can be trusted with a loan, you must prove two of three things:
- That you have the income to pay off the loan– this is done with financial documents such as a job contract, or recent bank statements.
- That you have a reliable credit score, which will depend on how well you have been repaying your debts.
- Or that you have assets that equal the value of your loan request.
Risks of Debt Consolidation
As enticing as the benefits of consolidation may be, it isn’t a one-size-fits-all solution. The first issue to consider is how it will affect your credit score. Every credit application pulls down your credit score. If you’re expecting to take out a more important loan soon, don’t consolidate your debt until after. It takes 1-2 years for a “hard inquiry” to be erased and for your credit score to return to normal.
When you take out a personal loan to secure your debt, you must put up a similarly valued item for the lender’s security. This could be your car or your house, and if you do not pay your dues, the lender may take this from you as repayment instead.
Another issue is the length of the loan and the amount of repayments you sign up for. If you move your debt to smaller repayments over a longer time, you could be unknowingly signing up for more interest in the long run.
And lastly are the pitfalls of using a debt consolidation company. Generally you should not do this, as there are monthly fees, and there is a high risk of being scammed.
Conclusion
There is no best way to consolidate your debt. Usually one method will suit you personally, but other times it will be better to hold off. But, for the majority of debts there is the chance for lower interest rates, smaller repayments, and more flexible payment schemes. In these cases, consolidating your debt can be a useful method for eliminating your debt.
Disclaimer:MoneyMagpieis not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.
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