What is Debt Consolidation?
Understanding this key debt relief process so you can make the right choices for your finances.
In general, letting outstanding debt linger in your financial portfolio is both risky and costly. Each month that passes without paying off a debt is another month of accrued interest charges that you have to pay. In addition, the monthly bills for debt tend to stretch your budget thin, putting you one emergency or unexpected expense away from potential financial distress.
That’s what makes financial processes like debt consolidation so valuable, because it can help you avoid challenging situations with debt – or it allows you to get out of a challenging situation with as little hassle as possible. The information below is designed to help you understand what debt consolidation is and how it can help you regain and maintain financial control. If you have any questions or want to explore options for consolidation, call us at 1-844-402-3073.
Basic definition of debt consolidation
In the simplest terms possible, debt consolidation refers to any financial process that rolls multiple unpaid debts into a single monthly payment. So instead of paying five bills, each with a different high interest rate, you pay just one bill that covers the payments for all of those debts.
There are two main goals with any debt consolidation plan:
- To simplify your bill payment schedule so you’re not juggling multiple payments per month.
- To reduce the interest rate applied to your debt so you can pay it off faster
Debt consolidation also usually lowers your monthly payments, although not in all cases. This is often a pleasant and much-needed side effect of achieving the first two goals.
Paying off debt faster even though you pay less
It may sound a little counter intuitive – that you can somehow pay less each month and still get out of debt faster than you would have been able to prior to consolidation.
This works out because of the second goal: reducing interest. By reducing the interest rate applied to your consolidated debt, more of each payment you make goes towards reducing the actual balance owed rather than paying off accrued interest charges. So even though you’re paying less in total, more of that payment is going to reduce the principal (the actual debt owed) rather than the accrued interest charges.
So if you have $5,000 in credit card debt spread out over five different cards at an average APR of 18% then the total monthly payments you make would be around $125, but roughly 2/3 of each payment made is getting eaten up by interest charges. You pay, $125 but $75 goes to cover interest charges – meaning you only reduce your debt by $50 even though you paid $125.
Additionally, it would take 273 payments to eliminate the debt in full on a minimum payment schedule. That means it would take over 22 years to eliminate your debt using traditional minimum payments. This is why minimum payments are typically considered one of the least efficient ways to pay off debt.
Now let’s look at the same debt in consolidation. If you consolidate that $5,000 using a debt consolidation loan at 5% APR for 60 months, then your monthly payment would be reduced to around $95. However, since the interest rate is so much lower, only about $20 goes to cover interest charges, while the other $75 goes to paying off principal.
As you can see, even though your monthly payment is lower in this second scenario, you’re actually paying off more principal debt each month that you do in the first scenario. So in 60 payments (5 years), you’ve eliminated the debt completely. It’s a faster way to eliminate debt because it’s more efficient.
What can you consolidate?
As a general rule of thumb, debt consolidation usually requires you to consolidate similar types of debts. So you can consolidate student loans together with a Direct Consolidation Loan and you can consolidate credit card debts with a debt management program, but there is really not an option that lets you consolidate the credit cards together with the student loans. Basically likes must be kept with likes when it comes to consolidation.
So let’s look at different options for consolidation and review what types of debt each can consolidate:
- Credit card balance transfer. This is where you transfer existing balances to a low interest credit card or (even better) one with a 0% APR introductory period. This option only applies to credit card debt.
- Unsecured personal debt consolidation loan. This is one of the most versatile options for consolidation because you can use the money you receive to pay off almost any debt you owe. This is usually used for credit cards, medical bills, furniture or electronic store accounts, personal loans and even payday loans. However, if all or some of the money is disbursed to you instead of directly to your creditors then you can use it for any debt reduction you want, even to pay off the remaining balance on your auto loan.
- Debt management program. This is a kind of assisted debt consolidation program administered through a credit counselling It generally applies to any kind of revolving debt. That includes credit cards, store accounts, medical debts, some payday loans and in many cases, any personal debt that’s been passed to collections.
- Home equity loan. A home equity loan – a loan where you borrow against the equity built up in your home – can be used to pay off outstanding debts, similar to an unsecured debt consolidation loan. Except your home is used as collateral to secure the loan. This is not advisable as a way to pay off your credit cards, since it puts your home at increased risk of foreclosure simply to pay off credit card debts that can’t tap your assets without a court order.