If you have large amounts of debt, you may have heard about debt consolidation and wondered if it could help ease the burden. A number of debt consolidation services promote lower interest rates, lower monthly payments, or both. If you’re struggling with debt, this likely sounds appealing, but it may not be worth it. In fact, with many debt consolidation services, you may end up paying more in the long run. So, what exactly is debt consolidation, and should you do it? To answer these questions, you need to understand what debt consolidation does, the different types of debt, and how debt consolidation affects the interest rate and term length of a loan.
If you need assistance in organizing your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs!
What is Debt Consolidation?
First things first. What is debt consolidation, and how does it work?
Debt consolidation is the act of combining different outstanding debts you currently have and bundling it all together. Essentially, you’re taking out a new loan to pay for your current loans. Debt consolidation can include debt such as credit card debt, student loans, medical bills, and car payments. Once you consolidate your loan, you’ll make one payment to cover all your consolidated debt, and you can theoretically pay a lower interest rate, make a smaller monthly payment, or both. Debt consolidation may sound simpler and cheaper, but the reality is that you may end up paying more.
Secured vs Unsecured Loans
In order to understand how debt consolidation works, it’s helpful to know the two main types of loans: secured and unsecured. Secured loans have an asset that acts as collateral for the loan, while unsecured does not have any collateral “securing” the loan. Credit card debt or medical bills are examples of unsecured debt, while a mortgage is an example of secured debt.
Unsecured debt is riskier for lenders since there is no guarantee that they’ll get their money. Therefore, unsecured debt often comes with higher interest rates than secured debt. Typically, debt consolidation is for unsecured debt such as debt from credit card bills, student loans, car payments, etc.
Debt consolidation loans are typically unsecured loans, but there are some exceptions. For example, you can consolidate debt by taking out a home equity loan. In this instance, your home becomes the collateral, and if you can’t make the payments, you may lose your home.
Contrary to what the ads may have you believing, debt consolidation doesn’t always mean a lower interest rate. The interest rate of the loan is at the discretion of the lender. Making matters even more complicated, the interest rate may actually change. This is especially common when credit cards offer debt consolidation through credit card balance transfers. Plenty of loan companies use similar, low-interest introductory rates as well, but only to bump up the interest rates later on. If you choose to consolidate your debt, you’ll want to find a fixed-rate loan.
The term length is perhaps the most noteworthy part of debt consolidation, but often the least discussed. The reason most debt consolidation services are able to offer lower monthly payments and/or lower interest rates is by extending the life of the loan. A longer-term loan means you’ll be in debt longer, but it also means you may end up paying more. Since interest accrues over time, the longer your loan, the more you’ll end up paying. This is often to the extent that it negates any savings from the lower interest rate. If you decide to consolidate your debt, make sure you compare the total amount you’ll end up paying.
Is Debt Consolidation Right for You?
A fixed-rate debt consolidation loan from a bank or a zero-interest balance transfer credit card can be a helpful debt consolidation option. The problem for many people with high levels of debt is that they don’t qualify for these options. Instead, they qualify for debt consolidation services that may offer lower interest rates or lower monthly payments, but they end up costing far more due to extended term lengths. If you have the ability to make your monthly debt payments, it can be far more beneficial to cut excess spending and make sure you understand why you’re in debt in the first place. If your debt occurred due to overspending or lack of a rainy-day fund, in order to truly get out of debt, you’ll need to change the habits that got you into debt in the first place.
Speak with a Professional Financial Advisor
You know what debt consolidation is now, but are you still wonder whether you should do it? If you’re looking for further assistance or more detailed advice, consider working with a professional from Good Life Financial Advisors. Our team looks forward to serving you!