Debt consolidation is pretty simple in theory. You take out one large loan to pay off several smaller debts in full. You then make payments on the larger loan each month instead of dealing with all of, the smaller individual ones. Ideally, the one required monthly payment is lower than the total of the payments you were making before, and the consolidated debt has a lower interest rate than the separate debts did. There are times when it makes sense to get a debt consolidation loan, and there are times when it does not. Here are some of the things you should consider when evaluating whether a debt consolidation loan is right for you.
1. Is the Interest Rate Lower Than What I’m Already Paying?
The first and perhaps most obvious question is this one. If your new interest rate meets or exceeds your current interest rate, then you will only end up paying more in the long run after you consolidate your debts. For instance, if you have three credit cards with interest rates of 21 percent, 19 percent, and 17 percent. You have a balance transfer credit card offer of 10 percent and a debt consolidation loan rate available of 8%.
In this case, it would make sense to either consolidate or transfer, because the interest rates on the cards all exceed the interest rates you would be paying on the consolidated debt by several percentage points. This would equate to paying less each month and less overall and less, a win-win. Of the two options described here, the debt consolidation loan provided the best opportunity because it had the lowest interest rate relative to the current rates on the cards. So in this situation, you would probably end up using the debt consolidation loan.
2. How Does the Monthly Minimum Payment Compare With My Total Current Payments?
As described in the above scenario, sometimes debt consolidation can reduce your monthly minimum payments considerably. If, in the above scenario, you were paying a total of $650 each month in minimum payments, it would make sense to consolidate if you could pay $450 or so each month. If you had to pay more each month, or the same amount, it might not make as much sense to consolidate, depending on how much lower the available interest rate was.
Keep in mind that having a new lower monthly payment does not mean that it is a good idea only to make that minimum payment each month. If you want to get out of debt, it is important to pay as much each month as you can afford on your debt, regardless of what the required monthly payment is. In other words, if your new monthly payment is $450 in the above scenario, it would be wise to keep paying the $650 to reduce the debt faster. It would be even better to pay $850 or more each month to eliminate the debt even more quickly. The quicker you repay your debt, the less interest you will pay, and the sooner you can be debt-free.
3. Would the New Interest Rate Be Fixed Or Variable?
This is a crucial question to ask. While a very low-interest rate may seem enticing, many forms of debt consolidation come with caveats and fine print that allow the lender to raise the interest rate for various reasons. They may even be able to raise it suddenly and without notice, which could put you in a very bad spot with increased monthly payments and a higher balance caused by the rate hike.
It is important to read all the fine print before you sign anything and to know precisely what you are getting yourself into when it comes to interest rates on any form of loan or credit card. Remember, most companies have maximizing their profits at heart, not your best interests!
4. How Quickly Can You Repay the New Loan?
It is imperative that you not be tempted by a lower interest rate and single monthly payment to spend your newfound “extra cash” on a shopping spree or vacation. You are still in debt and getting out as quickly as possible should be your priority. Don’t be tempted to rush out and buy that new model smartphone or the latest gadget. Instead, try to focus on making the largest payments you can on the newly consolidated loan.
It is important to keep in mind that because of the way interest works, paying double payments each month does not reduce your debt repayment time in by half. It reduces it by much more than half because you eliminate so much of the interest you would have paid the debt remained outstanding for several months or years longer!
5. Can I Avoid New Debt?
Another common temptation that hits people with debt consolidation is the temptation to take out other forms of debt. For example, if you consolidate all your credit card balances to one new loan with a low-interest rate, don’t go out and open a new store credit card to buy a new laptop! That would defeat the purpose of all your hard work. You must have the self-restraint to avoid taking out any new forms of debt, at least until after your new consolidated debt has been paid off in full.
Once you experience being debt-free, you may not want that new debt, after all. The feeling of freedom and spontaneity that comes from not having a bunch of credit card and loan bills looming over your head is liberating and is not something you’ll want to give up just to get a shiny new gadget.
6. Is Debt Consolidation Right For Me?
Debt consolidation isn’t for everyone, and that’s okay. If credit card offers and store ads easily tempt you, it might be better to teach yourself self-discipline and reasonable spending habits first. Avoid putting yourself in a position to be tempted further to make poor financial choices. If, however, you do have your spending under control and are working towards paying off your debts and improving your finances, then debt consolidation could be right for you. Just be sure to ask each of the above questions, do your homework, and read the fine print before signing anything.
With any luck, this article will prove helpful in answering your questions about debt consolidation loans and offers. We wish you the very best in reducing your debt and getting lower interest rates! If you have any tips or suggestions of your own to share with others considering debt consolidation, feel free to share them in the comments below.