Debt consolidation explained

Make sure that you have fully understand the debt consolidation.

You might find yourself in a situation with worsen financial health. One reason might be that you have many different debts and you fighting to meet your monthly payments. There are numerous reasons as to why you can not meet your monthly obligations. For instance, maybe your income has decreased, or maybe the interest rate on your loan(s) has increased due to changes in economic conditions. Another reason is that you have maxed out all of your credit cards, thus increasing your monthly financial obligations. Whatever the reason for your worsen financial health, you should find a way how to improve it. Namely, you should collect information about the strategies for repaying your debts, and/or improve your financial standing. The decision about the adequate strategy should be based on the reasons which have imposed the need for repayment of the loan. If the reason is some of the above-mentioned one, then maybe you should consider debt consolidation loan.

First, keep in mind that that there is a misunderstanding that when taking a debt consolidating loan, you are becoming debt free. You should know that debt consolidation is not as same as loan repayment in terms of repaying your loans and becoming debt free. Consequently, when consolidating your debt it doesn’t mean that you are a debt free. Instead, it means that you have the possibility to centralize different payments of your multiple debts with one bigger loan. You still have a debt as well as the obligation to pay the installment, on the consolidated loan, when it is due.

What is debt consolidation?

Debt consolidation can be explained as the process of merging multiple debts, into one single debt. You apply for a loan that is big enough to pay off all of your existing debts. The debt consolidation could be better understand through an example.Let’s say that you have a $40,000 of loan, also you have a three year car loan of $12,000 and a personal loan of $25,000. Your overall monthly payment obligation to service all debts is $1,600. For some reason, you struggle to meet the monthly payment. Thus you look information about the consolidation loans. You realize that you need a consolidation loan. Therefore, you apply for a consolidation loan of $77,000 that is enough to cover all debts you currently have. In addition, by taking a consolidation loan, you are able to lower your monthly payment from $1,600 to $900, having $700 less in a monthly payments.

 There are two basic types of consolidation loans – unsecured debt consolidation loan and secured consolidation loan. The difference between the tow is in the collateral requirement. Debt consolidation unsecured loans – the lender does not have any claim on your financial assets if you skip a repayments. This form of loan, very often bears a higher interest rate because the lenders is exposed to higher risk in case you default on the loan. In addition, you will be able to apply for smaller amount, so the lender don’t expose too much of it’s money.

Debt consolidation secured loans – are loans that are, as the name implies, secured against some form of asset. The most common asset is the home. Thus, not fulfilling your payment obligations could lead to loosing your home.  You will need to take a secure loan if you have high debt level or you have a poor credit score.

When do you need debt consolidation loans?

The primary reason as to why you would want a consolidation loan is when you are faced with a worsen financial health. But also, you might want to take a debt consolidation loan because of the possibility to reduce you overall debt expenses i.e. cost. Therefore, applying for a consolidation loan could be beneficial if:

  • You could be paying lower interest than what you are paying on your current debt.
  • You could, decrease the total monthly amount that goes towards meeting your financial obligation on various loans (debts).
  • Utilize some current offers form your (or other) lenders.
  • Improve your financial health in a sense that you could reduce the amount of the monthly payments on your debts.

When you don’t need debt consolidation loans?

            Since, it is briefly discussed when you need a debt consolidation loan, you should also know, when you don’t need a debt consolidation loan, even though it might seems like you need one. Accordingly, you should not apply for debt consolidation loan, if:

  • The consolidation loan is not sufficient to cover all current debts. Stated differently, you are taking the consolidation loan to repay all of your existing debts i.e. to merge them into one new loan. So, taking a loan, and still having other debts that can not be repaid, doesn’t make you better off. Instead, it makes you worse off, since you have increase the cost of your debt.
  • The loan will last much longer than the longest debt you currently have – this is a bit tricky to be taken for granted. But, it should be considered. If the time span of the new loan is much longer than the debt with longest maturity you currently have, then you have only prolonged the period of your indebtedness. Thus, pay special attention to the repayment period, before deciding on your consolidation loan.

What to do before applying for a consolidation loan?

As with everything else, there are some things to be consider, before applying for debt consolidation loan.

  • First and foremost, make sure that you are fully informed about all issues related to a debt consolidation loan. Be sure that you understand all the benefits and drawbacks of having a consolidation loan. Know the positive or negative impact on your financial health, beforehand.
  • Always ask for an advice before deciding. It doesn’t matter who you ask (financial adviser, friend, or lender) it is important to ask, because you could get additional information. But you should ask someone who is familiar with the issue of debt consolidation.
  • Debt consolidation options – examining the different possibilities, is also an important step before applying for consolidation loan. Although you understand the idea behind debt consolidation loan, you should shop for the best terms and offers on the market. Thus a good starting point is to find a reliable comparison site.
  • Compare the different consolidation loans on the basis of APR, fees, level of collateral needed (if it is secured debt consolidation loan). Also take into account all relevant aspects specific to your life style.
  • You could go directly to the bank or other institution that offers a debt consolidation loans. Make sure that you know how much interest you pay every month and gather all the relevant information. Beforehand, know how much is your outstanding debt, what is your credit score, and the reasons why you want a debt consolidation loan.
  • Stop using your credit cards, use them in emergency situations only. You are trying to consolidate your debt, thus, if you continue to irrationally use your credit cards, it means that you are increasing your debt again. So, what is the point of consolidating the debt, if you continue to create multiple debts?

Debt consolidation pros:

Improved cash flow – by consolidating all of your loans, into one bigger loan, you are able to improve your monthly cash flow. This is in a sense, that you can lower the size of your monthly payment, because you pay one installment, instead of multiple installments.

Better money management – consolidation loans enable you to easily keep track of financial obligations. Meaning that, as it was mentioned, instead of having couple of monthly payments, you have only one monthly payment for your new loan. Thus, making it much easier to service your loans, as well as improve the money management.

No negative effect on your credit score – you maintain clean track record of paying your debt obligations. Since you have paid off all of your debt, you will have a clear payment history, hence, there will be no negative effect on your credit score (keep in mind that in some circumstances there could be a slight negative effect).

Ability to save – combining all of your loans into a single loan enables you to save a portion of your income. Meaning that, because you can decrease you total amount which is going towards monthly payments to services your debt, you could have a higher portion of your income available for spending and/or saving. As a result, you could decide to deposit the difference between the old monthly installments and the new monthly installments in a savings account. By doing this (if it is possible) you are doing a very beneficial action for your financial healht in the future. Meaning that, you are repaying a loan and saving at the same time. Consequently, when you fully repay the loan, you will not be in a zero savings situation. You will have a certain level of savings.

Debt consolidation cons:

Keep in mind that creditors make more money when the repayment period of the loan is longer. Although debt consolidation can be beneficial in some circumstances, you should be aware that, at the end it might end up costing you more than the initial loans.

Fees and charges – pay attention to the fees and charges on your consolidation loan. These fees could be applied for the purpose of arranging the loan. Thus, make sure that you are informed about the fees, since they could eliminate any possible savings you might have with the consolidation loan.

Risk associated with using a secured loan – you are securing the loan against your asset. This means that in case of failure to meet monthly payments, your bank (lender) could take your assets because they have claim on it. Since the secured debt is most often secured against you home, you could end up loosing your home.

Paying debt with a debt – the danger of paying a debt with a debt exists if you are not a disciplined spender. Meaning that if you have a history of irrational spending of your money, than you should reconsider your spending habits because they are distorting your financial health. So, no matter how many debt consolidation loans you take, you will not improve your financial situation. On contrary, debt will continually increase, and you could end up being in a much worse financial situation.

Good debt consolidation loan is a loan that has low fees, competitive interest rate and adequate (flexible) terms. But before deciding on the consolidation loan you will apply for, you need to collect as much information as you can. Also, before making the final decision, it is of crucial importance for you to identify the reason that have stimulated you to consider the possibility of taking a consolidation loan. For instance, is it because of decrease in monthly income, is it because of some unexpected short term expenses, or whether it is because of unreasonable spending, and unreasonable borrowing.

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