When debt begins to pile up, and payments become a tangle, many people choose to consolidate their debt to avoid making what can seem like a million payments to numerous creditors. However, this option isn’t right for everyone, and there are multiple routes available when choosing how to pay off your debt. By analyzing how debt consolidation works, learning how to start the process and knowing what the payment options are, you can make a decision that can benefit your finances long term.

What Is Debt Consolidation and How Does It Work?

Consolidation is defined as “the process of uniting” by Merriam-Webster. Debt consolidation is the process of gathering all of your debt into one balance and paying off that single balance, often (but not always) handled by taking out a debt consolidation loan. Consolidating your debt has several advantages but an obvious one is the convenience of making one payment instead of multiple payments on individual smaller loans to numerous lenders or agencies.  

Debt consolidation can be handled on an individual basis or, more preferably, by a reputable credit management company that will work with you. Personal loans, student loans and credit card debt can all be consolidated. Many people opt to use credit card debt consolidation after falling into debt from multiple lenders with exorbitantly high-interest rates.

Is Debt Consolidation a Good Idea? Pros and Cons 

Consolidating your debt is beneficial for many people, but it requires a degree of stick-to-it-iveness and organization. The advantages of consolidation include:

  • A lower interest rate: Many consolidated debts have lower interest rates than all of the individual payments.
  • A shorter payoff period: These loans can be paid off in consistent payments that are slightly higher than the individual loans but decrease the total life of the loan, sometimes by years.
  • Organized finances: Nobody wants to feel that their finances are a mess. By having all of your debt in one place, you can begin to feel in control of the money you’re paying out.

Of course, this option isn’t right for everyone. The potential downside of consolidating your debt includes:

  • A regimented payment plan: If your finances are tight and you find it difficult to make regular payments, a consolidated debt with regular and fixed payments might not be the best solution for you. If you choose to use a debt consolidation loan or follow a plan from a third-party company, this will constrict your payment options even more.
  • Some people may choose a payment plan that extends for a long period of time to make smaller payments. This can be counterproductive in the long run as debtors may end up paying more than they would have saved. The key to avoiding this setback is to follow a useful plan by an experienced debt management company.

Payment Options After Consolidating Your Debt

Debt Management Programs (DMP)

Debt management programs, touched on earlier, are common when individuals want to consolidate their debt and pay it off in a consistent manner.  Many of these programs have monthly payments and serve as a go-between for the client and the creditor. The debtor pays the company they’re using in installments, and the company then pays the creditor after settling on an interest rate. The DMP manages the account where the client’s payments are deposited and charges interest on the account before forwarding the agreed-upon amount to creditors. 

Credit Card Balance Transfers

This option is great if a borrower can find a credit card that has a low-interest rate or outstanding benefits. Because many credit cards have an interest-free introductory period on the balance, debtors who choose this option will be able to make payments against their debt without worrying about additional interest from the credit card company. Of course, this route is only beneficial if the credit card has an extremely low-interest rate and the credit score of the person applying is good enough to guarantee such a rate.

Consolidation Loan

Many debt management and consolidation companies offer consolidation loans to participants in their programs or to borrowers who could not obtain such a loan elsewhere. So how do consolidation loans work? These loans are used to pay back the existing debt and then paid off themselves at a later date. The applicant’s credit scores, current financial situation and income, as well as their credit history will determine eligibility for a consolidation loan. Many people use this option because of the simplicity many companies offer. If current finances are not in a place where a person can make regular payments against a consolidated debt, a consolidation loan may be a good option under these circumstances.

Using Equity

Some homeowners borrow against their home equity to pay off a consolidated loan. If you have a reasonable amount of equity built up in your home and don’t foresee any large expenses in the future, this is a viable option to use. However, if there are fluctuations in the housing market or economic difficulties in your area, the equity lost could be detrimental to you in the long run. It isn’t a good idea to use substantial amounts of equity to pay off your loan, just in case you need the money later or you decide to sell your home sooner rather than later. Some homeowners may take out a home equity line of credit or loan if they don’t have enough equity in their home or choose not to use it.

Using Your 401(k)

A 401(k) account seems like a welcome source of available savings to pay off a debt. This money can be accessed and used to pay creditors but can come with a penalty. Although any fines get waived after age 59 and a half, many people can’t wait that long to access the money they need. There are two ways to take funds out of a 401(k): a hardship withdrawal or a 401(k) loan. Not all 401(k) plans allow a hardship loan, and the IRS only allows them for specific purposes. The 401(k) loan is usually the option if you choose to use the money for debt, but there are stipulations and numerous pitfalls to avoid. Borrowers will also, of course, need to eventually replace the money in the account.

Debt Consolidation and Your Credit Score

Debt consolidation may affect your credit score, depending on how you plan to pay off the loan. If you open a new account to pay off the consolidated debt, this can impact your score negatively. However, credit card consolidation involves closing accounts, which can reduce your credit utilization ratio. By making regular payments, you can lower your utilization ratio even more over time. If you don’t need to use a consolidation loan, you won’t run the risk of being denied a loan or accruing more debt. Overall, there are more positive benefits than negative ones when it comes to the impact debt consolidation can have on your credit score.

Debt consolidation is a great way to regain control of your finances and set yourself on a path to security. Borrowers can watch as their debt shrinks and their credit score rises provided they use the right method of payment. Whether you choose to borrow against your equity or use a consolidation loan, following best practices and sticking to a debt management plan will help you become debt-free in the end. Fresh Start offers debt consolidation services as well as consolidation loans. Our professional team can point you toward a useful debt management plan and even work with creditors to settle your debt. Contact us at 800-346-9559 today to take the first step toward being debt-free!