What Is Debt Consolidation?
Debt consolidation means taking out one loan to pay off your other debts. For example, you might consolidate student loans, credit card debt and an auto loan into one new loan. Doing so allows borrowers to roll multiple debts into one loan with a single monthly payment. Ideally, consolidation loans provide a lower interest rate and payment amount. As a result, debt consolidation is a viable strategy for getting out of debt.
How Debt Consolidation Works
Debt consolidation allows borrowers to combine multiple debts into a single, larger loan or onto a credit card. The goal is to get better terms and a lower interest rate for more affordable monthly payments.
The first step in getting a consolidation loan is filling out an application with a lender. The lender will check your identification, credit, income and debt-to-income (DTI) ratio (the amount you owe versus the amount of income you bring in each month).
If the lender approves the consolidation, you’ll receive a new loan, usually with new terms and a new interest rate. A common type of loan for debt consolidation is a personal loan that enables you to pay off your existing debt. However, you may have numerous options for consolidating debt.
Options For Debt Consolidation
You can use several types of debt consolidation methods to reduce your payment and lower the interest rate. Here are some of the debt consolidation methods that may be available.
Debt Consolidation Loan
Debt consolidation loans are available as personal loans or home equity loans through banks, credit unions or online lenders. Borrowers use the new loan to pay off their old debts and repay the new loan over time.
Borrowers who don’t want to risk their possessions can use an unsecured personal loan. This option allows the borrower to receive a loan without tying it to their home, car, jewelry, etc.The disadvantage of this loan is that it has a higher interest rate than a secured personal loan. That said, refinancing with an unsecured loan will likely get you a lower interest rate than your current form of debt, making consolidation one of the most popular personal loan uses.
Credit Card Balance Transfer
A balance transfer moves debt from one account to another. This type of debt consolidation is typically only used for credit card debt. A balance transfer is advantageous when you obtain a new credit card with a 0% introductory annual percentage rate (APR). This way, you can transfer a balance from a credit card with an APR of 20% or more to a card that doesn’t charge interest for a guaranteed period (usually 6 – 12 months). Instead, you’ll pay a one-time transfer charge that typically ranges from 3% – 5% of the balance.
For example, say you transfer a $10,000 credit card balance from an account with an APR of 18% to a card with a 0% APR. You pay a $500 transfer fee and halt the interest charges of about $150 per month. Therefore, the transfer fee is worth the interest savings.
Home Equity Loan
A home equity loan allows you to tap into your home equity to consolidate your debt. Lenders typically allow you to borrow around 85% of the equity in your home with a home equity loan. You’ll receive a lump sum, which you pay off with a fixed interest rate based on a fixed payment schedule. Because a home equity loan is a second mortgage, you’ll put your home up as collateral for a home equity loan.
Home equity loans provide low interest rates because of the collateral required. As a result, they are suitable for debt consolidation if you’re looking to reduce your monthly payment and save money over the long haul. Remember, you can use a home equity loan with a primary or secondary home.
Home Equity Line Of Credit
A home equity line of credit (HELOC) is another type of second mortgage that allows you to borrow against the equity in your home. Your equity becomes a revolving line of credit you can tap during a span of time called the draw period. It usually lasts 5 – 10 years, and you can continue using the line of credit if you make the required minimum monthly payments.
When you reach the end of your draw period, you’ll shift to repayment mode and must make full interest and principal payments. Lenders usually require you to have at least 15% equity in your home and allow you to borrow up to 85% of your equity.
Remember, HELOCs use your house as collateral for the loan. Therefore, you could also lose your home if you stop paying on the amount you’ve borrowed. So, this type of loan benefits homeowners in a solid financial position to make their payments.
Cash-Out Refinance
A cash-out refinance provides homeowners with a lump sum based on their equity. For example, if you have a $250,000 home, and you owe $100,000, you could refinance into a $200,000 loan and use the excess to pay off your credit cards or installment debts and the closing costs of the loan. Then you could take a check home for anything extra leftover. As a result, a cash-out refinance means tapping your equity and acquiring a larger mortgage balance.
Refinancing your mortgage can give you a stockpile of cash to repay other debt and provide a lower interest rate. Remember, having an adequate amount of equity is necessary for this option.
Student Loan Refinance
Student loan refinancing consolidates your student debt. Because a student loan usually applies to one semester or year, you’ll likely finish your education with multiple student loans with various interest rates. Refinancing will put your student debt into one new loan and potentially provide you a lower interest rate.
Remember, consolidating federal student loans means they become privately held. As a result, consolidated loans aren’t eligible for government student loan forgiveness programs. So, it’s best to consolidate student loans if you know you won’t receive any type of student loan forgiveness.