Debt Consolidation Loans: Understand Your Options

If you feel like you are constantly worrying about how to make your next credit card payment, you are not alone. Around 80 percent of Americans struggle with debt. You do not have to be an extravagant spender to find yourself in this position.

US total household debt has skyrocketed in recent years, reaching a peak of around $14 trillion in 2020.

US Household Debt_1200x-ClearOne

US household debt has surpassed $14 trillion in 2020. (Source: Reuters.com)

 

What can you do if you find yourself burdened by financial worry? Where can you find debt relief?

Your options could include credit counseling, debt consolidation, debt settlement, and bankruptcy. Before making a decision about debt consolidation, you need to know the answers to a few questions, such as:

  • What is debt consolidation?
  • What are some different types of debt consolidation?
  • How does debt consolidation work?
  • How does debt consolidation compare to other debt relief options?
  • What are the pros and cons of debt consolidation?
  • Who are the best candidates for debt consolidation?
  • Does debt consolidation hurt your credit score?
  • What are the qualifying requirements of consolidation loans?
  • Is debt settlement a better option for you?

 

What Is Debt Consolidation?

Debt consolidation is the act of rolling different types of debt into a single liability.

Your first step toward consolidating your debt, or bringing it all under one roof, is to pay off all your credit card balances, with their high-interest rates, varying due dates, and attached terms. You can accomplish that by taking out a debt consolidation loan.

In other words, you pay off one debt with another. Personal finance experts generally advise against such a strategy. Why?

It's because you need to be extremely careful in choosing your loan. For a debt consolidation loan to be a good option, there are several things that must be true:

  • The loan needs to give you a better (preferably fixed) interest rate.
  • Excluding your mortgage payment, your total debt should not be more than 40 percent of your gross income.
  • You should have a workable plan in place to avoid charging any more on the credit cards that you are consolidating.
  • You should have sufficient income to cover the consolidation loan payment every month without undue hardship.

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Types of Debt Consolidation

Unless you manage to secure a loan that helps you meet those requirements, the only advantage your debt consolidation can give you is that of an easy-to-remember payment schedule. As always, the devil is in the details. Haphazard moves could land you a loan with worse terms than those of the debt you are replacing.

DebtSettlement

 

Credit card balance transfers

A credit card balance transfer involves the transferring of balances from higher-interest credit cards to a new one that offers a better interest rate and benefits. Such transfers usually incur a transfer fee. In some cases, the credit card company may waive this fee.

Often, credit card balance transfers are subject to introductory interest-free periods of up to 18 months.

The pitfall is that a violation of the cardholder agreement voids the setup. That means that you may end up paying surprise interest charges and penalties.

Pay close attention to all the numbers involved, including the APR and the transfer fees. In many cases, with transfer fees included, you may end up doing nothing more than breaking even or worse, paying more in the long run.

Unsecured loans

An unsecured loan can be a good option, provided you get the right terms for it. Such a loan does not put your home on the line. With it, you do not run the risk of foreclosure.

The better your credit score, the better your debt consolidation loan terms can be. This is why you need to be in decent financial shape for a consolidation loan to represent a real option for you.

Home Equity Loan

A home equity loan is a lump sum that the credit provider pays to the homeowner. Its amount depends on the homeowner’s equity (the current value of the home, minus any outstanding mortgage balance). The advantage of home equity loans for debt consolidation is that generally, home equity loans have a low-interest rate.

The disadvantage is that the loan terms may be stretched over an extended period of time, meaning that this option may not be the quickest way to repay your debt entirely. Another disadvantage is that, because the home equity loan is secured by your home, if you should default on your payment, you could jeopardize your home.

A HELOC (Home Equity Line of Credit)

Unlike a home equity loan that has a fixed payment amount each month, a HELOC works like a credit card. The lender establishes an amount limit, based on your home equity, and a time limit. Within these confines, you can borrow money as you need it.

HELOCs may represent a viable debt consolidation solution, provided you are in good financial shape. Remember that a HELOC acts as a second mortgage and is, therefore, a secured loan. That means that if you should default on your payment, you would jeopardize your home.

How Does Debt Consolidation Work?

Let's take a look at the following example to understand how debt consolidation works. You currently have a debt amount of $26,000 at 18% interest. If you just make the minimum payments of 3% starting at $780 per month, it could take you 10 years to pay off and cost over $21,000 in interest. If you consolidate the debt to a loan with a 5.8% APR and pay about $500 per month, it would take you 5 years and cost about $4000 in interest.

The only thing to keep in mind is that in order to qualify for a loan with a low-interest rate, you need to have a good credit score and a debt to income ratio that is not too high.

 

Debt Consolidation Loans vs. Debt Settlement

You have to be aware that a debt consolidation loan does not settle your previous debts. It can merely offer you a better way to deal with them.

 

  Debt Settlement Debt Consolidation Loan
Monthly Payment of Debt Reduced, based on the renegotiation of debt Dependent on terms of the loan
Upfront Fees None Origination fee and possibly some transfer fees if you opt for credit card balance transfer
Typical Program Length 2-5 years 2-5 years
Financial Benefits Short term relief and long-term relief. Forgiven debt. Lower/fixed interest rates
Qualification Regular income. A minimum of $10,000 in unsecured debt. Good credit score, good debt-to-income ratio, home equity in the case of secured loans.
Impact on Credit Score Significant, but not as bad as Chapter 7 and Chapter 13 bankruptcies. Low. Initial negative impact, long-term positive impact.
Other considerations Visible progress takes at least three months. In the case of secured loans, you risk your property.

 


The Pros and Cons of Debt Consolidation

Pros

  • It simplifies debt payment making it more transparent and easier to control.
  • It eliminates variable-rate loans and replaces them with a single, fixed-rate, closed-ended liability.
  • It creates monthly savings through more favorable interest rates.
  • It allows disciplined people to set up an emergency savings fund.

Cons

  • Secured loans open you up to losing your home/ car.
  • It may make some people falsely believe they have resolved their previous debt issues.
  • Paid-off credit cards may tempt some into financing new purchases if left active.
  • To get a good interest rate on your debt consolidation loan, you need a strong credit score. Banks and credit unions do not typically give loans to those with credit scores below 580.
  • Finding the best possible loan is time-consuming.
  • Loans may carry origination fees.
  • There may be an initial negative impact on credit score.

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Who Should Consider Debt Consolidation Loans?

The person best suited for a debt consolidation loan is:

  • In a decent financial situation, with a good credit score. If your credit score is poor, you cannot get a good deal on your loan. It makes no sense to roll your burdensome debts into an even worse single package.
  • Responsible and disciplined. The best course of action is to avoid using the credit cards that you have paid off through the loan again. Some people find it helpful to put these credit cards aside in a space that is not easily accessible, leaving just one card with a low credit limit in their wallet in case of an emergency.

 

Do Debt Consolidation Loans Hurt Your Credit Score?

According to Nerdwallet.com, debt consolidation loans can cause a temporary dip in your credit score. This dip results from the hard inquiry on your credit that accompanies the strategy.

The long-term effect of debt consolidation on your credit score can be positive, as long as you meet the terms of the loan and maintain the discipline required to avoid using credit cards that you have consolidated.

 

What Are the Requirements to Qualify for Debt Consolidation Loans?

To qualify for a debt consolidation loan, you need to be in decent financial shape. What this means is that:

  • You have a stable work history.
  • You do not pay too much in monthly minimum debt payments. If you pay more than 50% of your income towards debt, you likely do not qualify.
  • Your credit score meets the requirements of the lender.
  • You have decent equity to offer in the case of a secured loan.

 

Can a Debt Consolidation Loan Really Help You Get Out of Debt?

Under the right circumstances, it can provided you fulfill the qualifying requirements, you are disciplined, you earn a proper income, and you have your mindset on ridding yourself of debt.

 

Is Debt Settlement a Better Option for You?

Debt settlement is focused on reducing the total amount of debt you owe, while debt consolidation aims to reduce the number of creditors you owe and the amount of interest you pay.

With debt settlement, ClearOne Advantage negotiates with your creditor, aiming to gain forgiveness on some of your balance. The results of these negotiations are often astounding. Creditors often are willing to cut balances in half, but it's not unheard of for a creditor to reduce a balance by up to 70%.

ClearOne Advantage debt settlement can be the better option for you if you do not qualify for a debt consolidation loan. If your financial situation is truly dire, but you still feel you can afford to make a partial payment to your creditors, you owe it to yourself to consider the benefits of debt settlement with ClearOne Advantage before taking a drastic step like bankruptcy.

ClearOne Advantage is here to help. Our Certified Debt Specialists have helped thousands of satisfied clients break free from the burden of out-of-control debt. To learn if debt settlement is the best option for you, speak with one of our Certified Debt Specialists at 888-340-4697 to get a personalized debt relief plan.

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