What Is Debt Consolidation and How Does It Work?

Managing personal finances is often put on the back burner until multiple debts are accumulated. It is only then that people start seeking ways to put their finances under control by consolidating debt.

But what is debt consolidation exactly, and is resorting to it an effective solution? The simple answer is: Yes if you can obtain a lower interest rate. It entails taking out a new personal loan to consolidate all the other debts and streamline repayment. This article will help you determine if this solution is right for you, so read on.

What Is Consolidating Debt About?

A debt consolidation loan allows borrowers to combine multiple debts into one. This can be helpful for people struggling to keep up with several monthly payments because it enables them to manage a single obligation instead of multiple ones. Most debtors choose this strategy to benefit from a lower interest rate, pay off debt faster, and simplify their finances.

How To Consolidate Debt

A debt consolidation program can be an effective way to reduce monthly payments, save on interest charges, and become debt-free more quickly. But how does consolidating debt work? You need to complete a few steps before applying for a debt consolidation loan, so let’s see what these are.

Reasons for Drawing a Debt Consolidation Loan

Debtors typically consider taking out a debt consolidation loan or signing up for another form of debt consolidation for the following reasons:

  • Simplifying finances: You keep track of one instead of multiple monthly payments.
  • Reducing monthly payments: You pay lower amounts thanks to a lower interest rate and an extended amortization period.
  • Reducing the amount of interest: A lower interest rate results in more money going towards the principal than interest charges.
  • Paying off debt faster: With interest not making up such a big chunk of monthly payments, you can put more money toward paying down the principal and repay the debt sooner.

Debt Consolidation Requirements

To be eligible for a debt consolidation loan, you must be employed and creditworthy. If you have a poor credit history, you may want to check out how you can improve your credit score before applying. Once you meet these requirements, you’ll likely need to provide:

  • Letters from creditors or repayment agencies
  • Documentation stating your credit history
  • Two-month statements for every loan or credit card debt you wish to consolidate

Debt Consolidation Steps

The debt consolidation process usually consists of the following steps:

  1. Prequalification: Research lenders and examine their offers.
  2. Comparing several offers: Focus on the loan amount, repayment period, and interest rate. Don’t forget to take origination and processing fees into account.
  3. Applying: Double-check the information in the documentation you provide to ensure it doesn’t contain errors.
  4. Getting approved and receiving funds: Repay the earlier debts to creditors and lenders, or let the new lender do so if they offer such services.

From this point on, you have only one loan to pay off.

Debt Consolidation Example

Suppose you have a $9,000 debt on three credit cards with different annual percentage rates (APR) – 24.9%, 18.9%, and 12%. You receive a debt consolidation loan offer at a 7% annual rate. The structure of your payments and interests for each would be the following:

Credit Cards Consolidation Loan

Debt per card/loan and an
accompanying APR

$4,000 (24.9%)
$3,000 (18.9%)
$2,000 (12%)

$9,000 (7%)

Total debt aAmount $9,000 $9,000
Payment duration (in years) 4 4
Monthly payment $275 $216

Common Types of Debt Consolidation

Not all debt consolidation types are equal, so it’s important to learn more about the various strategies at your disposal before you choose the type of debt consolidation that fits your needs.

Debt Consolidation Loan

Lenders typically approve debt consolidation loans of up to $50,000. The repayment period and interest rate depend on the lender, but it’s common for terms to last between one and 10 years. These loans are a good solution for debtors with favourable credit card scores, who are likely to obtain a lower interest rate and a shorter loan term.

Credit Cards

Many owners of credit cards in Canada are aware of what debt consolidation means and how it works. They consolidate various payments by transferring them to a new credit card with little to no interest for an introductory period.

To avoid credit cards that quickly accrue large amounts of debt due to high interest rates in the first place, you should explore some of the most favourable credit cards on the market.

Home Equity Loan

Compared to debt consolidation loans and credit cards, home equity loans, known as the second mortgage, come with lower interest rates and optionally higher loan amounts because the home serves as collateral. The loan term can be as long as 30 years, and the amount as high as 85% of the home’s value.

Student Loan Programs

Though this article has answered the question, “What is debt consolidation?”, you may now wonder if any such option is available for students. Absolutely. The Canadian government offers a few programs, including direct loans you can check out. Private loans don’t qualify for the program.

How To Decide if Debt Consolidation Is the Right Move

So, who is debt consolidation for? Different debt consolidation strategies favour different types of borrowers. If unsure whether debt consolidation is for you, refer to these pros:

  • You can pay down the debt faster.
  • Debt consolidation will work for you better if you have a good or excellent credit score.
  • If you have substantial equity in your home, getting a home equity loan can help you consolidate your debt.
  • You can streamline the process by merging multiple payments into one.
  • Debt consolidation can eventually help improve your credit score.

On the flip side, debt consolidation might not be a good idea for borrowers who:

  • Have a bad credit score
  • Aren’t eligible for a lower interest rate
  • Can’t afford to pay off the debt in a short time

Does Debt Consolidation Hurt Your Credit Score?

Your credit score can decrease when you close a few accounts during the consolidation process. However, the positive impact on your score comes from reducing the number of debts, making regular payments, and lowering the credit utilization rate. Most importantly, your score will eventually improve if you make all payments on time after consolidating your debt.

How long debt consolidation remains in the credit report depends on your loan type.

Strengths and Weaknesses of Consolidating a Debt

Debt consolidation comes with obvious benefits but also some downsides, so comparing both is essential to make an informed decision. Let’s quickly review the key debt consolidation pros and cons.

Advantages

Borrowers opting for debt consolidation enjoy some or all of these perks:

  • You consolidate multiple debts and continue paying off only one.
  • The credit score can improve as a result of on-time payments.
  • The strategy can help you secure a lower interest rate on your debt, especially if you have an excellent credit score.
  • Depending on the amount you owe, consolidating debt can save you thousands of dollars during the payoff term.
  • Debt consolidation eliminates the need to keep track of multiple debts and bills, simplifying the process and preventing miscalculations that could lead to late payments.

Disadvantages

So, is debt consolidation worth it or not? Consider the following possible drawbacks:

  • You risk your home if you use it as collateral for a home equity loan.
  • You might end up paying more interest over time if the interest rate is similar and you choose a longer loan term.
  • Associated costs, such as origination, transfer balance, and other fees, can reduce the overall savings, so it’s essential to factor those in.

Final Words

Now that you’re familiar with the debt consolidation definition and what this debt management strategy entails, you can proceed with finding a program that will help you reduce your debt and improve your financial stability. Check out the leading lenders and their conditions and compare offers before making the final decision.

Also, ensure you can keep up on-time payments since missing them will lead to additional fees and, as a result, increase the total amount of money you owe and adversely affect your credit score.

Remember that having a good credit score helps to get approved for a consolidation loan with reasonable conditions. So, if you can only apply for credits with less favourable terms at the moment, work on improving your score before applying for a loan, if possible.


FAQ

How does debt consolidation work?

Debt consolidation usually involves taking out a new loan to repay multiple debts. The new loan preferably has a lower interest rate than your other debts, saving you a substantial amount of money in the long run.

What is the debt consolidation loan disadvantage?

The main disadvantage of debt consolidation is associated costs, such as origination and other fees, which can reduce the overall savings, so it’s essential to evaluate these expenses carefully.

Is debt consolidation a good idea?

Debt consolidation helps you replace various obligations with a single one. Taking it is a good idea, provided that you can lower associated interest rates and pay off your debt faster.

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