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What is Debt Consolidation: Is It The Right Strategy For You?

Created on 11 Nov 2023

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What is Debt Consolidation: Working, Types, Ways, Pros and Cons - Insider by Finology

Were you aware that the EMI for home loans has spiked around 20% over the last couple of years? People issuing credit cards to pay for both basic and non-essential needs are also seeing a major rise over the years. Just look at the infographic below to see the rising trend. โคต๏ธ

People issuing credit cards to pay for both basic and non-essential needs are also seeing a major rise over the years. Just look at the infographic to see the rising trend.
Source: Statista

Credit cards can be a double-edged sword. On the one hand, more credit cards in citizen’s hands could mean a rise in lifestyle. While on the other, they can lead to a mountain of EMI payments and debt. No matter the scenario, the end result would be you holding a mess of finances with all the increasing payment requirements. โŒ

Interestingly, people handling debt are usually found in two categories: one who wishes to pay off their debts as soon as possible and be free of the burden, and the others who believe in paying their dues in time as they don’t like limiting their lifestyles over EMI payments. If you fall under the first category, then this article would be a goldmine of information for you.

And if you are the second type, you should still read it. You might be convinced to change your tactics for debt repayments; you never know! ๐Ÿ˜‰

Let’s begin with the strategy we will be discussing here.

Debt Consolidation: How Does It Work?

Loan repayment strategies are many, but debt consolidation is considered to be one of the most effective of them. And for good reasons. It helps you with the opportunity to maintain a healthy credit score and get loans at lower interest rates, among other benefits. But how exactly does it work?

So, debt consolidation means getting a new loan, with lower interest rates if possible, and paying off other loans with that credit. This way, the borrower will have to mark off just one EMI payment per month and will be able to load off the liability baggage with a better balance.

You can either get a new credit card with multiple benefits or apply for a personal loan to pay off the other debt. It’s as simple as that.

Or is it? ๐Ÿค”

Every coin has two sides. Learning about both the sides before utilising debt consolidation as your repayment strategy is essential. This leads us to the question…

Should you be consolidating your debt?

Here are the questions you need to ask yourself first. โคต๏ธ

Q.1 How was your debt generated?

Do you love maintaining a lavish lifestyle and going on shopping sprees? If this is how you accumulated debt, then debt consolidation is not for you. Wonder why? Well, the strategy won't reduce your debt amount but only help you decrease the number of payments you make. So, either you will have to change your shopaholic ways or find other loan repayment strategies. So, think deeply about it and then go ahead with it.

Q.2. What's the tenure of your existing debt?

If the tenure for the end of your existing debt is somewhere between 1 and a half years, then this strategy is not the ideal choice for you. Getting a new loan would only end up increasing your debt tenure and might also lead to an increase in the interest amount you would be paying.

So, my advice would be to hustle and finish off your loans in the limited time left. But, if the debt tenure extends the period mentioned above, then, by all means, roll on with the strategy. Only answer one last question first.

Q.3. What is your credit score?

If you have a low credit score, below the standard 690-720, then I would advise against debt consolidation. Yes, this strategy helps increase your credit score, but it could also lower your score with frequent speed if you miss payments. To know how your credit health is, check the image below. ๐Ÿ‘‡

Also, if you want to know how to check your credit score & how to get loans with a low credit score? then click here.

Credit Score Master - Insider by Finology

And, if you want to check your credit score for free, then click on the link.

Now that you have decided whether the debt consolidation is suitable for your finances, it’s time to check other details about the strategy.

Types of Debt Consolidation

Debt consolidation can be further classified into two categories:

Secured Loans: This kind of loan requires the borrower to offer up collateral, such as a home, car, or other valuable asset. Secured loans typically have lower interest rates than unsecured loans because they are less risky for the lender.

If the borrower defaults on the loan, the lender can seize the collateral to recoup their losses. Home equity loans, personal loans, etc., are some of the examples of secured loans.  

Unsecured Loans: It is the kind of loans that do not require collateral. This means that the lender has no collateral to seize if the borrower defaults on the loan. As a result, unsecured loans typically have higher interest rates than secured loans.

Credit card balance transfers and unsecured personal loans are examples of unsecured loans.

Ways You Can Consolidate Your Debt

There are many ways to get started with debt consolidation, as the examples above state. Let’s explore the most common ones:

Credit Cards Balance Transfers

This is one of the most common ways people use to consolidate debt in modern times. Credit card balance transfers mean getting a new credit card with favourable terms instead of keeping several high-interest cards simultaneously. This tactic is very efficient in terms of both risk & interest rates and is thus preferred as a first choice by many.

Home Equity Loan

If you own a home, you could utilise the property’s equity to apply for a loan. Then, you could use the credit to consolidate your loans, so you will have to worry about paying off just one loan in your finances.

Personal Loan

You can simplify your financial liabilities by getting a personal loan from either a bank, a lender, or a credit union. With the help of a new personal loan, you could pay off other loans and get a shorter duration for payments.

Remember how I mentioned that debt consolidation has both good and bad parts? Let's check what they are.

Advantages of Debt Consolidation

  • Lower interest rates: When you consolidate your debt, you can often get a lower interest rate on the new loan. This is because lenders are more willing to offer lower interest rates on larger loans and because they view consolidated loans as being less risky.
  • Faster repayments: Debt consolidation can also help you pay off your debt faster. This is because you can often get a shorter loan term on a consolidated loan. Additionally, the lower interest rate can free up more money each month that you can use to pay down your debt.
  • Improve credit score: Debt consolidation can also contribute to improving your credit score. This is because it can lower your credit utilisation ratio. Additionally, making on-time payments on your consolidated loan will help to improve your credit history.
  • Streamline finances: Debt consolidation can also streamline your finances. This is because you will only have one monthly payment to make instead of multiple payments to different creditors. This can make it easier to track your spending and manage your budget.

Disadvantages of Debt Consolidation

  • Increase loan duration: When you consolidate your debt, you may have to extend the loan term in order to get a lower monthly payment. This means that you will be paying interest on your debt for a longer period of time, which could increase your overall interest payments.
  • Increase interest payments over time: If you consolidate your debt into a loan with a higher interest rate than your current debts, you could end up paying more in interest over time. It is important to compare the interest rates on all of your debts before you consolidate to make sure that you are getting a lower interest rate.
  • Missed payments: If you miss a payment on your consolidated loan, it could damage your credit score and make it more difficult for you to qualify for loans in the future. It is important to make sure that you can afford the monthly payments on your new loan before you consolidate your debt.
  • Not a financial issue-solving strategy: Yes, this con needs to be addressed. Debt consolidation does not address the underlying financial issues that led to your debt in the first place. If you do not change your spending habits, you could easily fall back into debt after consolidating your loans.

As Dumbledore would say, “Happiness can be found, even in the darkest of times, if one only remembers to turn on the light.” ๐Ÿง™‍โ™‚๏ธ

The Bottom Line

Debt consolidation is undoubtedly a good loan repayment strategy, but it comes with its dose of what-ifs. So, it’s essential that you ask the necessary questions and then decide whether you should be utilising it. If you are going to try up a new tactic, it’s imperative that you do it to its utmost excellence, right? Tune in to Insider to learn about similar investing strategies and company analysis to strengthen your finances further.

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Preeti Gupta

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A book-lover who adores everything fictional, Preeti has undertaken the life mission of tasting every flavour available in the pantry. A science student with a Master's in Mass Communication, she now wishes to conquer the Finance world as a writer. With the power invested by the randomly chosen music, she is here to make Finance fun for you.

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