6 Things To Understand Before Applying For Debt Consolidation
When one’s debt management becomes too much to handle, debt consolidation is one of the first solutions that should come to mind. It works by taking out one loan that is used to pay off all outstanding debts.
The interest rate that the consolidation loan carries is typically less than the average interest rate of the individual's other debts, and this loan type provides two major benefits:
- Paying less money in interest overall
- One single monthly payment to worry about
While debt consolidation is one of the best options to get debt under control, it is important to understand how it works before applying.
Below are 6 things that anyone considering debt consolidation should take into consideration.
- Stay Away from DIY solutions
- Converting unsecured debt to secured debt
- Consolidation is not free
- Stick To The Planned Payment Schedule
- Debt Settlement And Debt Consolidation
- Consider Your DTI
Stay Away From DIY Solutions Unless You Have A Good Credit Score
The most common DIY debt consolidation method involves using a personal loan or line of credit to pay off one’s debts.
This option is only suitable for those who have a good credit score and are able to qualify for low interest rates.
Applicants with a poor credit score may not receive a better interest rate than their current debt carries.
DIY strategies should only be undertaken by those who have a history of good debt management and can get favorable interest rates.
Be Careful Of Converting Unsecured Debt To Secured Debt
Although unsecured debt is subject to higher interest rates than secured debt, it is preferable for a variety of reasons.
Unsecured debt does not require the lender to pledge an asset to guarantee the loan, meaning there is nothing the lender can repossess should the borrower default on the loan.
Also, unsecured debt can be released outright in a chapter 7 Bankruptcy filing, whereas secured debt cannot.
Secured debt, such as mortgages, car loans, and HELOCs, are best suited for individuals who have a firm control over their finances.
Those who are struggling to get out of debt, and who may be in somewhat of a precarious position, are at greater risk of defaulting on their secured debt and losing the asset placed as collateral.
Consolidation Is Not Free - Be Aware Of Fees
Nearly all debt management solutions come with fees. High fees can make debt consolidation efforts less economically viable if the borrower does not thoroughly examine them beforehand. The most important charge to look out for is the 3% balance transfer fee that comes with a credit card balance transfer.
Anyone considering a balance transfer as a means of debt consolidation should make sure that even with the 3% charge, they still stand to save more money than they would by continuing with their current credit card.
After Consolidating, You Need To Stick To The Planned Payment Schedule
After setting out on a debt consolidation plan, most individuals find themselves motivated to stick to the planned payment schedule.
Unfortunately, many lose track and focus somewhere along the way, start missing payments, or even using their now balance-free credit cards.
Doing this is likely to put the borrower in a worse situation than where they started, and exacerbate their financial problems overall.
The most dangerous trap is slipping into old spending habits, so remember that this is always the ultimate remedy for financial wellbeing, alongside consolidation methods.
Debt Settlement And Debt Consolidation Are Not The Same Thing
Debt consolidation and debt settlement are not the same. Debt consolidation refers to combining all outstanding debts into a single monthly payment at a lower interest rate.
Debt settlement is an entirely separate process in which a third party negotiates with one’s creditors in hopes of reaching a payment agreement for less than currently owed.
Debt settlement requires a single lump sum payment to one’s creditor and can severely harm their credit score. Some commercials are misleading and it can be easy to confuse these two terms.
Always Consider Your DTI
The debt-to-income (DTI) ratio is a very important financial metric that is used by lenders to calculate a person's creditworthiness.
It provides a great deal of insight into an individual's relationship with debt and a picture of their current obligations.
DTI refers to the percentage of one’s gross monthly income that goes towards servicing their debts.
A high DTI is likely to make a person ineligible for a consolidation loan with a good interest rate. A good rule of thumb is to try to keep your DTI under 36%.
Any person who is serious about taking action to reduce their debt should strongly consider consolidation. This process allows individuals to focus on a single monthly payment as well as take advantage of lower interest rates, which could save thousands of dollars, depending upon the size of their debt.