How To Consolidate Debt (2021 Guide)
Debt consolidation is the process of taking out a loan to replace multiple existing unsecured loans. The whole point is to do away with making multiple repayments and instead simplify life with a single repayment. Debt consolidation also works if a borrower wants to change the due date of existing debts.
Lower interest is another reason for debt consolidation. The process is often used to replace high-interest debt like credit card debt with a loan that comes with a lower interest payment amount.
Borrowers consolidate debt in order to reorganize their finances and pay off their debts faster as a result. Debt consolidation works well if your debt is within reasonable limits and you have a decent credit score.
There are quite a few ways in which you can consolidate debt and we will explore them in this guide so you can better understand your options at hand.
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Debt Consolidation Loans
As pointed out in the paragraphs above, the most common way to consolidate debt is to take out a loan that replaces multiple smaller loans.
Many of the brand-name banks and certain non-profit debt consolidation companies offer such loans. There are some for-profit debt consolidation services available online as well.
When working with a debt consolidation company, keep an eye on the fees and charges that the company charges you. It will increase the cost of borrowing such loans.
If you find these services to be too expensive, then approach a bank or your local credit union for a lower interest rate and fee structure.
If you happen to have bad credit, then you might not be able to work with conventional institutions like banks. In that case, you may have to find a reputed debt consolidation company and try working with them.
No matter who you work with, always be vigilant against scams and read all the terms and conditions before you sign anything.
Balance Transfer of Credit Cards
The main motivation behind a balance transfer is to avoid interest payments or perhaps lower the interest payments being charged on credit card debt.
Some credit cards offer an introductory 0% APR on balance transfers for the first 12-16 months when you sign up so you can gain yourself some time to pay down that debt before interest accrues.
Alternatively, look for a credit card with a low interest rate than what you currently have on your debt. It makes sense to transfer the debt over to that new credit card to save money. For this to happen, you will need your card limit on the low-interest option to be high enough to accommodate all of the incoming debt balances.
If your credit card limit isn’t high enough, then you can still try to transfer your most expensive credit card debt to the low-interest option. The rest of the card balances can stay where they are. This way, you can at least work towards easing the interest burden partially.
Before you do any balance transfer, carefully work out the total cost in doing the transfers. Companies often charge a fee for doing a balance transfer. So, your total cost should end up saving you money rather than making things worse than where you already were in the first place.
Use home equity
If you have paid off a portion of your mortgage or if your home’s value has gone up, then you are probably holding some home equity. You can monetize this equity by using a home equity line of credit (HELOC) or a home equity loan to access funds to pay off your smaller existing loans.
By doing this, you effectively replace multiple loans with a single home equity-based loan. This home equity loan will be a closed-ended account which you will repay back over a certain duration, as per the terms and conditions of the loan or the line of credit.
The advantage of using home equity-based loans is that they come with comparatively higher borrowing limits and have a lower interest rate.
The disadvantage of these loans is that if you fall behind on the repayments or if you default, then you could lose your home. Foreclosure can be much worse than defaulting on credit card debt and taking a hit on the credit report.
It’s a great strategy that helps you avoid having to sell your home to access the equity. You can keep your home and use the equity in it to pay off your higher interest debts, saving you on interest costs overall.
Loan against insurance policy
This is not the most desirable option, but if you have a life insurance policy, then you can borrow up to a certain amount below the value of that policy. That money can then be used to repay existing debts.
If you repay the loan against the policy, then everything works out well. However, if you default on the loan, then your life insurance is essentially gone. Your beneficiaries or heirs will not receive any money from that policy.
Taking a loan against an insurance policy is like picking between bankruptcy and life insurance. That is why this isn’t the ideal option.
You can also simply borrow money against the insurance policy and not pay any interest if the loan is much less than the value of the policy. The insurance company, in such a case, may not pay out any money to your heirs when the policy becomes payable.
Therefore, it is always a good idea to make payments on the loan even if there is a no-payment option.
This is another last resort option that is not recommended. It involves you borrowing money against your 401k retirement plan and then using that money to repay multiple existing smaller loans.
The terms of such loans are strict and you have to repay back the loan in 5 years. If you cannot do that, then the loan will be deemed as an early withdrawal and you will be subjected to a penalty and an income tax on that amount by the IRS.
If you leave your job, then you have to repay back the loan within 60 days of the leaving date. Otherwise, the loan will again be deemed as an early withdrawal.
This option of consolidating debt isn’t ideal because not only is your retirement balance getting cut, but you are also at the risk of paying penalties and taxes.
Change Your Lifestyle to Get Out of Debt Quicker
Ultimately, no matter which route you take towards debt consolidation, none of them are a permanent solution to your debt problems.
In order to truly achieve financial independence, you need to figure out a way to manage your finances. You have to strive to stay out of debt or keep debts to a manageable level.
If your debt isn’t very large, then try and pay it off within a few months by making some adjustments to your lifestyle.
Debt consolidation works best when you have a good credit score. Good credit borrowers can get interest rates which are much lower than credit card interest rates.
If you have decent income or cash flows coming in, then it makes sense to consolidate debt and pay it off over time. Having enough money to make debt repayments adds visibility and gives you the confidence that you will be debt-free within a specific time period.
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