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How Does Debt Consolidation Work?

Debt consolidation is ideal for those who are paying a high average interest rate on their debt and are making several different debt payments each month. Unlike debt settlement, which reduces the total principal that you owe, the goal with debt consolidation is to roll all your debts into a single payment at a lower interest rate. A lower interest rate will often lower your monthly payment, making it easier to afford your debt burden and even though you may pay it off early.

How debt consolidation loans work step-by-step

  1. Start by reviewing your monthly statements to total up the unsecured debts you would like to pay off.
  2. Also, determine the average interest rate you’re currently paying, so you can compare rates on loans.
  3. Next, review your budget to find a monthly payment you can afford. Make sure your budget includes the following:
    1. Rent or mortgage payments
    2. Groceries
    3. Entertainment
    4. Savings
    5. Other recurring costs
  4. It may also be a good idea to check your credit. You can evaluate if your credit is strong enough to qualify for a debt consolidation loan at a low-interest rate.
  5. Next, you should shop around to find the best loan and lender to fit your needs.
    1. Contact your bank or credit union
    2. Use an online loan comparison tool to compare offers from other lenders
  6. Once you find a loan that provides the amount, rate, and terms that fit your needs, apply for it.
    1. Only apply for the loan that best suits your needs. Applying for multiple loans in a short span of time can damage your credit!
  7. The lender will review your credit and verify your income to ensure you qualify. If so, you will receive approval and work out the final terms of your loan.
  8. Once you finalize the terms, the lender will disburse the funds to pay off your credit cards and other debts.
  9. With your other debts paid off, you only need to be concerned with keeping up with the new loan payment each month.
Couple reviews a debt consolidation loan online

Loan term versus monthly payment

As you set the terms of a loan, it’s important to understand the relationship between the term and payment requirement. The term is the amount of time you have to repay a loan. It determines the number of installment payments you will make to pay off the money you borrowed, along with interest.

A shorter-term means you have less time to pay back everything you borrowed. As a result, the required monthly payment will be higher. However, that means fewer months for the lender to apply interest charges. Thus, a shorter term will decrease your total costs.

By contrast, a longer-term will lower the required monthly payment. However, it will increase the total cost of borrowing.

In general, you should choose the shortest term possible that provides monthly payments you can comfortably afford to make.

How will the funds be disbursed?

It’s important to ask the lender how they will disburse (release) the funds from the loan.

  • Some lenders will deposit the funds into a bank account of your choosing. You will receive the money and it will be up to you to use it as intended to pay off your existing debts.
  • In some cases, the lender may require direct disbursement. This means that they send the money directly to each of your creditors. They will get account numbers and current balances on each account from you and send the money accordingly on your behalf.

Make sure to check with the lender on which method they will use, so you know what to expect.

Does Debt Consolidation Work? An Example with $25,000 in Credit Card Debt

Consider this example. Suppose that you and your spouse have five credit cards, each with a balance of $5,000. The minimum payment required for each account is calculated as 3 percent of the balance owed, which is a relatively standard minimum payment calculation.

Each card has a different interest rate – 14%, 16%, 18%, 20% and 22% APR.

This means you have five monthly payments to manage each month, each with a different due date. The starting minimum payments would be $150 on each account. Your total monthly payments would be $750.

At an average APR of 18%, you will pay $24,297.26 in interest charges before you pay off your balances. The total cost of getting out of debt would be $49,497.26 – nearly double what you owed.

What’s more, you must juggle those five payments with your paycheques, which increases your chances of missing one.

By contrast, let’s say you get a $25,000 debt consolidation loan at 10% APR. You choose a term of 5 years or 60 payments. The monthly payment amount would be $531.18, meaning you would save $218.82 per month. You also would only have one bill to pay each month.

The total interest charges on the loan would be $6,870.57. You would pay $31,870.57 to get out of debt for a cost savings of $17,626.69.

  Interest rate Monthly payment Total interest charges Total cost
Without consolidation 18% $750 $24,297.26 $49,497.26
With consolidation 10% $531.18 $6,870.57 $31,870.57

Does debt consolidation work differently than other solutions?

A debt consolidation loan works by securing new financing to pay off your existing debts. There are a few other solutions that do largely the same thing:

  • A balance transfer credit card pays off existing credit card balances with a new credit card, rather than using a loan.
  • A Line of Credit (LOC) pays off existing debts, using an open revolving credit line, rather than a closed installment loan.
  • A home equity loan uses funds from a closed installment loan, but the loan is secured using your home as collateral; a debt consolidation loan is unsecured.
  • A Home Equity Line of Credit (HELOC) also uses an open revolving credit line, but it’s secured using your home as collateral.

The goal will each of these options is to get new financing at a much lower interest rate. Borrowing at a better rate allows you to pay off debt more efficiently.

Alternatives to new financing

There are other solutions that do not rely on new financing to pay off your existing debts.

Debt Management Plan

With a debt management plan, you set up a repayment plan through a credit counselling organization. You still owe your original creditors. The credit counselling organization simply acts as your liaison to arrange for an adjusted repayment plan with each creditor.

You make the one monthly payment to the counselling organization, which they distribute each month on your behalf. Your creditors receive monthly payments and you pay off your debt in full with reduced APR.

Debt Settlement

Debt settlement is significantly different from debt consolidation because it does not pay off everything you owe. It works by paying off a percentage of the principal debt that you owe.

With a debt settlement program, you may still be required to make monthly payments to the settlement company. However, they do not pay your creditors each month; rather they hold the funds to generate the money needed to make settlement offers to your creditors.

This can result in severe damage to your credit score, due to missed payments and charged-off balances. However, it may be a viable option if you’re facing challenges like debt collections.

Finding the best solution for your needs’s trained debt relief specialists can help you identify the best solution to use based on your needs, credit, and budget. Before you decide if debt consolidation will work for you, talk to a trained professional to review your options for free.
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