Debt consolidation programs: What to know

In a world where credit is widely available and there is no shortage of temptations to consumers, it stands that lots of people find themselves in debt at some point. This is stressful in itself, and it can become a chronic financial drag if there are multiple debts, and worse if interest rates on the debts are high.

But having multiple debts is a problem that can managed and finally overcome. Through debt consolidation, you can gather multiple debts into one payment through a personal loan, a balance transfer credit card, or a debt management plan, to name just a few strategies. In many cases you can move debt from high interest accounts to a much lower rate that is easier to manage and finally pay off.

Understanding debt consolidation

Most debt consolidation strategies involve asking a lender to help you roll together one or more debts into one loan that has easier terms and a lower rate.

These are often high-interest credit card debts, but can also include personal debts, medical bills, etc. Instead of trying to manage multiple accounts and seeing their bottom lines increase under crippling interest rates, you now manage one account with a strategy to bring down debt over time. Of course, you can always speed the path to a zero balance by paying more than the monthly minimum whenever possible.

You should know that certain secured debts, such as a mortgage, auto loan, or home equity loan, cannot be consolidated. Also know that bad credit debt consolidation loans can affect your credit score at least temporarily, but we’ll cover that more later.

Benefits of debt consolidation

The best way to consolidate debt can look different for everyone, but in a good plan, the goal is to join bills into one balance so that you make one monthly payment. If done properly, debt consolidation makes paying off debt less stressful and ultimately saves you hundreds, if not thousands, of dollars in added interest.

Major benefits to consolidating credit card debt are:

• A single monthly payment: You’ll be combining multiple debts into a single monthly payment, simplifying your bill-paying process.
• Lower interest rate: People frequently find themselves paying very high interest rates on credit card debt after the card’s introductory low rate expires. You may be able to secure a much lower interest rate with a debt consolidation option, especially if you have good credit.
• Longer repayment term: A consolidation option can provide a longer repayment term than you had with your previous debts, giving you more time to pay them off.
• Better credit utilization ratio: If you pay off credit cards with a personal loan, you can lower your credit utilization ratio and improve your credit score over time.
• Consistent payments: Personal loans usually come with a fixed interest rate. So, if you use a personal loan to consolidate debt, your minimum payments will probably be the same each month, unlike with a credit card.

Common methods of debt consolidation

Depending on things like your credit score, types of debt, and severity of your debt, there are some ways to consolidate debt that work better than others, and some that won’t work at all. So what is the best option for debt consolidation? Here are the options.

Balance transfer credit cards

Say you have big balance on a credit card that is accruing interest at a high rate. You can move the principal balance from that card to a lower interest balance transfer credit card. There is typically a balance transfer fee of 3% – 5%, but the lower rate makes it easier for you to pay the debt faster and save money on interest.

Fixed-rate debt consolidation loans

You can use a debt consolidation loan, which is usually just a personal loan from a traditional bank, credit union, or online lender, to pay off outstanding debts and replace them with one monthly payment. Ideally this new loan will have a lower interest rate that saves money, but know that personal loans require a minimum credit score to get a good rate.

Borrowing from retirement

If your 401(k) plan with your current employer allows it (not all plans do), you might be able to pay off some or all of your debts with a loan from your own retirement savings. Even if the plan does allow this, the top amount you can borrow is typically limited. But it doesn’t require a credit check and any interest you pay goes back into your 401(k).

Borrowing from your home equity

If you’ve accrued equity in your home (the difference between its value and how much you owe on your mortgage), you might be able to secure a home equity loan or a home equity line of credit (HELOC) to pay off your other debts. The risk here is that your home becomes collateral. If you default on the loan, the lender can take your home through foreclosure.

How debt consolidation affects your credit score

The answer to the question “Does debt consolidating hurt credit” is yes, at first, but if you’re successful in paying down your debts your credit score will rebound and become stronger over time.

If your debt consolidation plan requires you to open a new credit account, your score will take a hit because this will open a hard inquiry on your credit. But as you pay your debt down you also reduce your credit utilization ratio — this is the percentage of all your available credit that you’re using. As that percentage becomes lower, your credit score can begin to go back up.

There is also a chance you might lose your credit cards if you consolidate your debts. Typically, if you hire a debt management company, they may require you to freeze your credit accounts while they assist you through the process.

If you take out a debt consolidation loan and pay off your credit cards, however, those cards usually can remain open for you, though the lender may choose to reduce your credit limit. And be aware that some lenders who make debt consolidation loans will require you to close credit card accounts as a condition of the loan.

Steps to consolidate your debt effectively

There are many steps and often significant passage of time in the process of consolidating your debts and paying them off. But most fall under one of three categories and in this order: Prepare, research, and execute the plan.

Gather your financial information

Whether you’re seeking a debt consolidation loan, enlisting the help of a debt settlement vendor, or taking on a balance transfer credit card, you will likely need any or all of the following documents:

• Bank statements, pay stubs, at least 2 years of past tax returns
• Credit card statements, even for those that carry no debt, that show the annual percentage rate, current balance, and monthly interest payments
• Statements on mortgage, car loans, and any other debt statements
• Credit reports from at least one, but better all, of the three major credit reporting agencies

Determine how much you currently pay a month for all the debts you wish to consolidate into the new plan.

Create a realistic budget

Create a realistic monthly budget, based on your current income, that includes all known and regular fixed costs (rent, car, bills, food, etc.) but without the payments on credit card debt or other debts you wish to consolidate. If the budget is so tight that you can’t make significant payments on debt, consider ways to reduce expenses and/or increase income, such as with a second job.

Working your way back to a healthy financial balance often can be done using the 70-20-10 rule. This approach to budgeting sets aside 70% of your take-home pay for living expenses and discretionary purchases, 20% for savings and investments, and 10% for debt repayment or donations.

Choose the right consolidation method or program

Make sure you know all of your options before choosing a plan. If your financial knowledge is weak, find a trusted advisor. Start perhaps at your bank or credit union. Choose an option (personal loan, balance transfer credit card, etc.) and then shop around for the best deal. And finally, execute the plan — practice good financial discipline and make the payments on time, every month.

Budget to avoid future debt

If you’re in the process of paying down your debts, know that even if you get your debt down to zero, you’ll need the same discipline to avoid going into debt again. People who stay out of debt and begin to grow their wealth for the future all learn to set and keep to a budget. Here are some of the key elements of a healthy budget:

• Tracking expenses: Add up the cost of all the things you know you pay every month – rent, car payment, insurance, bills, groceries, gas, etc. – and try to account for unexpected or non-monthly expenses. You can make a strong estimate of monthly expenses by averaging your past 6 months of bank statements.
• Determine monthly income: If you’re an employee, this is your monthly net pay after taxes; if you’re a business, you may have to take the average of the last 12 months.
• Make savings goals: Ideally you’ll have more than one savings account – one for emergencies and unexpected expenses, one for a down payment on a house, one for investment or even tithing.
• Compare your income to known expenses: Add your savings goals to your known monthly expenses. Hopefully your monthly income exceeds this number. If not, consider a side hustle for extra income or find ways to reduce spending.
• Stick to the plan: A budget is only as strong as the person in charge of it. Growing your savings always starts small, but if you have the discipline to spend less than you earn and you invest wisely, you can grow wealth exponentially to meet your financial aspirations of the future.

The bottom line: Consider debt consolidation to simplify payments

Debt consolidation is probably a good strategy for you if it simplifies your debt repayment and gets all your debt under a single, lower interest rate. It can help you boost your credit score after a short time, but it will likely cause an initial credit hit when you consolidate.

Interested in a debt consolidation loan? Start your personal loan application with Rocket Loans^SM today.