Monday, 12 June 2017

If you're in debt, you're not alone. In fact, according to a 2016 report, American households with credit card debt owe an average of more than $16,000.

That's just credit card debt and doesn't include mortgages, car payments, and other kinds of debt. The average household with any kind of debt owes $135,924, including mortgages, according to Nerdwallet.

Needless to say, many people are looking for a way to eliminate or gain control of credit card debt, and using a debt consolidation loan can be a viable option.

1. What is debt consolidation?

Debt consolidation typically refers to combining multiple outstanding debt balances into one account. Ideally, the one account would have a lower interest rate, or at least could save you money on fees. This, in theory, would enable you to decrease the interest and fees you pay, allow you to put more money toward the principal balance, and pay off your debt faster.

What's more, because you'd be paying one payment each month instead of multiple payments, you would simplify your monthly money management and reduce the possibility of missing a payment, which could damage your credit rating.

2. How does a debt consolidation loan work?

You would apply to a lender, most likely a bank or credit union, for a loan in the amount you need to cover your outstanding credit card balances. This would be a personal loan, typically unsecured by collateral. If approved, you would use the proceeds from the loan to pay off your credit card balances and then begin making monthly payments on the loan based on the agreed-upon loan terms. 

3. What are the benefits?

There are many. As mentioned previously, the chances are good the interest rate on your loan will be lower than the rate on credit cards, which typically have relatively high interest rates. This would allow you to pay less in interest each month and put more toward the debt itself.

You would also have set monthly payments. With most credit cards, your monthly payment changes based on your balance. If your balance goes up, so does your payment. With a loan, you would make the same payment every month, allowing for better budgeting and more financial stability.

Also, with a loan you cannot get into additional debt. Many people consolidate credit card debt into one, lower-rate credit card account. However, this still enables them to use the card and incur more debt. A loan does not give you this option

4. What are the potential negatives?

Because the loan will most likely be unsecured, and if you're applying for one you're already in some debt, it could be a bit more challenging to be approved. Also, again, because the loan is unsecured, the rate may be higher than, say, a home equity loan. However, if you can get approved, the rate will probably be below that of a credit card, so it would still be better to use the loan versus leaving the balances on the cards.

However, make sure you run the numbers to see what the what the actual cost of the loan will be once it is paid off. Keep a close eye on fees and other charges which could make the loan more costly in the long run. Also, you probably want to borrow from a reputable lender like a bank or credit union. If you do turn to a debt consolidation company for your loan, make sure you research the company and their reputation.

One of the biggest potential pitfalls with any debt consolidation plan is not controlling spending after you have consolidated your debt. As mentioned before, many people consolidate multiple credit card balances onto another credit card, then proceed to use the credit card to make purchases. That approach can create more problems. The same can be true with a loan. Chances are if you consolidate your credit card balances with a loan, you're going to have a substantial monthly loan payment. Make sure you can manage the payment without relying on credit cards every month.

Even though you cannot use the loan to make additional purchases, your credit accounts will remain open and available for use after you have paid their balances off with the loan proceeds. That can be risky, so some people choose to close the accounts to eliminate the temptation to use them.

When carefully considered, a debt consolidation loan can be a valuable tool to help you get out of credit card debt. However, careful selection of the right loan is important. Consult a trusted financial consultant to see if a consolidation is right for you.

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