Financial advisors usually recommend prioritizing paying off debts on time to maintain a good credit score. However, having several debts with different monthly payment schedules and interest rates can be overwhelming.
One solution to address the matter would be to get a debt consolidation loan.
What is a Debt Consolidation Loan and How Does it Work?
A debt consolidation loan is a combination of all your multiple existing debts rolled into one. This usually includes lower monthly payments, lower interest rates, or both. It is essential to take note that this type of loan does not erase your multiple existing debts, but simply transfers it into a single different type of loan or lender.
When a consumer is faced with many debts, they can apply for a debt consolidation loan to combine all those debts into one and pay them off. Payments are then made until every single debt combined is fully paid.
Consumers usually apply for this type of loan through their bank, credit card company, or credit unions. On top of that, you can also check for debt consolidation loans, including other installment loans online.
Types of Debt Consolidation
Secured and unsecured loans are the two types of debt consolidation loans. A secured loan is a type of loan that is backed up by collateral. The collateral can be any asset owned by the borrower, such as a car or a house. Moreover, the collateral will serve as security for the lender if the borrower fails to pay the debt.
On the other hand, an unsecured loan is a type of loan that requires no collateral. This usually comes with higher interest rates and can be challenging to obtain. Aside from debt consolidation loans, there are also other ways to consolidate your debt. Below are the most common:
- Credit Cards: This can be done by consolidating all your credit card debts into a new credit card
- Home Equity Loans or Home Equity Lines of Credit (HELOC): This is also another form of consolidation in which the interest is deductible for taxpayers who particularize their deductions
- Student Loan Programs: The government offers consolidation programs for consumers with student loans through the Federal Direct Loan Program
Pros and Cons of Debt Consolidation Loans
- It is an excellent option for people who have multiple existing debts with high monthly payments or interest rates
- You only have to worry about one monthly payment rather than several payments connected to various debts
- You can save yourself from calls and letters from several collection agencies, as long as the debt consolidation loan is kept up to date
- A debt consolidation loan may positively impact your credit score, provided that you make proper payments
- You may get a tax break. As mandated by the Internal Revenue Service (IRS), you cannot deduct interest in an unsecured debt consolidation loan. However, if it is a secured debt consolidation loan, you may get a tax deduction
- Debt consolidation loans may have a longer payment schedule, which also means you may pay more in the future
- Having this type of loan may cause interest rate discounts and other rebates to disappear
- Some debt consolidation services may charge you higher initial and monthly fees
- It may hurt your credit score. This is because credit score favors longer good standing debts with good payment history, and having to consolidate debts may show your inconsistency
What’s the Difference Between Debt Consolidation and Debt Settlement?
Both debt consolidation and debt settlement are financial strategies used to improve your debt load. However, both offer different functions to help resolve different kinds of issues. As mentioned above, debt consolidation is combining all your existing debts into a single debt. This type of loan helps cut down the total debt you owed.
On the other hand, debt settlement helps you out by cutting the number of lenders you owe. It does not combine your existing debts into a new loan, unlike debt consolidation. Instead, it offers a series of negotiations between you or your credit counselor and the creditor to reach an agreement to lessen the amount you currently owe (usually in a lump-sum type of payment).
The creditor is not required to make such negotiations or accept any offer. However, it is possible to come to an agreement if the creditor thinks that your offer is the best option to redeem even just a portion of your loan. Moreover, a debt settlement process is not usually done in one sitting. It usually takes time and may not reach an agreement.
Before you apply for a debt consolidation loan, it is wise to make sure you can afford to make payments. You wouldn’t want to see yourself having a much bigger debt at the end of the day. Moreover, it would help if you do your research and analyze if this type of loan is the best option for your current situation.
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