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Looking for ways to improve your finances? Debt consolidation can be a useful tool to pay off what you owe on credit cards, car loans, medical bills and other debt.
There are several good reasons you might want to consolidate: you've committed to pay down your debt, you want to save money by paying lower interest, you'd like to improve your credit score, you're looking for a way to simplify life, and you want to avoid missed or late payments.
The drawback? Some people consolidate their existing debt into a new loan and then add more debt to the credit cards they just paid off, leaving themselves even deeper in debt. But a good plan can help you avoid this.
What Is debt consolidation?
This is the process of using a new loan to pay off other debts, combining multiple outstanding balances into a single loan with lower interest and/or better payment terms. Once you've paid off all the smaller debts using money from the new loan, you then make just one payment each month on the new loan.
3 Things to consider when consolidating debt
While a debt consolidation loan may not be right for everyone, here are three benefits to the approach.
1. It can be a smart way to save money and pay off debt
When you refinance your existing loans, credit cards, and other debts into one loan, you have the chance to lower the interest you pay. Just as you would with a mortgage refinance, you'll want to compare your current monthly payments, interest rates, and terms with those of the new loan to make sure the move indeed saves you money.
One way to see if consolidation makes sense for you is to use Global's debt consolidation calculator. This online tool helps you compare new loan terms against your existing debt to see if consolidation will save you money. The calculator allows you to compare monthly payments, total interest, total payments, and potential overall savings.
2. You'll have just one monthly payment
When you take several debts and consolidate them into one loan, you simplify life by taking multiple payments and due dates and narrowing it down to just one payment each month. Some people find that this makes it easier to pay down debt faster, since they have just one balance on which to focus. And, if you're able to lower your monthly payment by consolidating to a loan with lower interest, you can use the money you save each month to pay extra towards your loan principal.
Missing and late payments cost you money in late fees; they also hurt your credit score, so consolidation can help you in more ways than one.
3. Consolidating debt may increase your credit score
Interestingly, when you consolidate debts from multiple sources into one loan, it could result in a short-term dip but an overall long-term increase in your credit score for a net positive bump. Why?
The short-term dip may happen for a couple reasons. First, like applying for any loan, the application process for a debt consolidation loan includes a hard inquiry on your credit, which may lower your credit score by a few points. Also, opening any new credit account may temporarily lower your credit score because it lowers the average age of your credit accounts overall—an important factor for determining your creditworthiness.
However, your credit score is based on other factors, including something called credit utilization. This measures how much of your available credit is in use. Experts say you should not use more than 30% of your total available credit. By getting a new loan and using it to pay off other debts, you may increase the amount of available credit you have without increasing the amount of actual credit used, which could increase your credit score.
Also, many people find that debt consolidation improves their ability to pay bills on time, since they just have one deadline to manage. Your payment history has a big impact on your credit score, so improving this will certainly help improve your credit score. And, as you continue to pay down debt over time, this helps even more.
Types of debt consolidation loans
Depending on your circumstances, you may have several options for the new loan:
- Unsecured or secured personal loan
- Personal line of credit
- Home equity loan
- Home equity line of credit
- Balance transfer credit card—choose a card which offers low fixed-rate interest
You can learn more about each of these options at the links provided. Once you are approved, you can use the money from the new loan or credit card to pay off your other debt. Then you pay back the new loan over time—ideally at a lower interest rate than what you had been paying.
Alternatives to Debt Consolidation
Taking on a new debt consolidation loan is just one approach to managing your overall debt. If you decide to pay your existing debt down where it is, it's a good idea to decide up front how you want to go about it.
Here are two popular approaches; choose the one that makes the most sense to you:
Debt snowball
Once you've made your minimum payment on each loan or credit card, then make an extra payment (as much as you can afford) towards the debt with the smallest balance. Once that is paid off, then move to the next smallest debt. Paying down debt this way allows your success to snowball, giving you a sense of accomplishment while also simplifying your life as you reduce the number of payments you make each month.
Debt avalanche
This approach is like the debt snowball approach but instead of making extra payments to the debt with the smallest balance, you make the extra payments towards the debt with the highest interest rate, to pay it off first. Once that is fully paid, you can then move to the next most expensive debt.
A note on avoiding future debt
It takes a lot of work and commitment to pay down your debt, so once you've done so, you'll want to avoid a repeat. Here are some proven techniques to keep your finances on track:
- Develop a budget and stick with it.
- Build an emergency fund to help you cover unexpected expenses.
- Consider putting off big expenditures such as a new car or a big vacation until you've got money saved in advance.
Let's face it—spending money can be a lot of fun. But when you have a mountain of debt in your way, the fun times can fade quickly.
Fewer debts can lead to more success
The process of taking multiple debts and consolidating them into just one loan can be a good strategy under the right circumstances. Debt consolidation is one technique you can use to help pay down what you owe, save money, and possibly increase your credit score.
Interested in consolidating your debt? At Global, we have several debt consolidation tools available to members. Give us a call at 800-525-9094 to discuss your options.
