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What is Debt Consolidation and when does it make sense?

Debt consolidation is the process of rolling up a variety of other debts and obligations into one single loan. It could be a variety of debt. Student loans, medical debt, credit cards, etc. Debt consolidation may be a smart choice in some cases, and you end up with a single lower monthly payment. In some situations, debt consolidation can help you to pay off previous debts quicker and with less pain than with the status quo.

If you have a manageable level of debt and you are looking for a lower interest rate and to better manage your finances, debt consolidation may be the right solution for you.

What are some ways to consolidate your debt?

There are a few approaches that can be used to consolidate debt. They should all enable you to reduce the number of payments you make, and in some cases, you may end up with only one monthly payment. Ideally, the amount which you pay every month is also lower and you end up paying less money over the life of the loan.

Balance transfer

Depending on your credit, you may be able to get low or zero interest balance transfer offers from a few companies. Citibank and Discover often have low-interest balance transfer offers if you have a good credit score.

Consolidation loan

Some companies specialize in offering consolidation loans. There are many options, but Prosper and Lending Club are two examples. In this case, your credit does not need to be stellar but it will still require a decent score. In addition, oftentimes the better your score, the better your interest rate and terms will be.

Home Equity Line of Credit (HELOC)

Taking a second loan against your home is another method that can be used to pay off all your credit cards. One advantage of this approach is that you should be able to get this type of loan even with some blemishes in your credit history. The main disadvantage of this approach is that it converts unsecured debt into secured debt and if you cannot make the payments, you may end up losing your home.

401k loan

Another approach to consider is to take out a loan against your 401k. You may be able to borrow $50,000 from this account. This approach does not require a credit check and any interest you pay will be paid back to your 401k. So, essentially you are paying interest to yourself. Like all other options, it does have drawbacks. If you are unable to repay the loan you may end up having to pay taxes on that money as well as potentially some stiff penalties. Additionally, if you leave your current employer, you may find that the full balance of the loan becomes due immediately.

When is debt consolidation a good idea?

Here are some general guidelines about when it’s a good idea to consolidate your debt into one loan:

  • All your outstanding debt monthly payments including student debt do not exceed 40% of your gross monthly pay.
  • You have good enough credit to qualify for a 0% balance transfer offer.
  • Your income can comfortably cover the monthly payment that is required by the consolidation loan.
  • You have a plan in place to pay off the existing debt as well as to not continue to accumulate debt in the existing cards.

Here is a sample scenario of when debt consolidation makes sense:

  • You have 4 credit cards with balances and the APR on those cards is anything from 18.99% to 24.99%.
  • You are making timely payments on these credit cards
  • Your credit score is in a decent range
  • Your current income exceeds your current expenses
  • You can obtain a new loan with a lower interest rate than your current rate
  • You pay off all or most of the debt in the existing cards
  • You don’t accrue any additional debt

When is debt consolidation not a good idea?

Debt consolidation is not a magic bullet that will solve all debt issues. Underlying issues may need to be addressed. For example, if your current expenses will still exceed your current income after you get your debt consolidated, other measures will need to be taken in addition or instead of the debt consolidation. Otherwise, your problems will persist, and you will continue to dig yourself deeper into debt. For this reason, it’s essential to analyze your finances before getting yet another loan.

Alternatives to debt consolidation

In some cases, a debt settlement program may make more sense, and in some cases, declaring bankruptcy may be the smartest way and perhaps the only viable alternative. Everyone’s situation is different. We highly recommend calling one of our solution specialists today. They can help you determine the best route to financial freedom and to a debt-free life. Call us today at (800) 558-2718.