Credit card debt is common in the United States, with the average American having a credit card balance of over $5,000 in 2020. With high interest payments and large principal balances, it can be difficult to pay off credit card debt, resulting in a snowball effect that makes deleveraging difficult, if not impossible.
A common way around this problem is called debt consolidation. This practice can be helpful, simplifying the process of paying off debt. It can also help you get a lower interest rate that allows you to pay more for the principal of the debt, paying off the total more quickly. But, there are some downsides to debt consolidation. Before taking this step, it is essential to know as much as possible about how it works and its impact on your finances.
How does debt consolidation work?
There are many debt consolidation programs and products available. In general, debt consolidation involves taking out a new loan or credit card and consolidating all of your existing debt into one monthly payment that you pay through that loan or card. You then make a payment each month on the new line of credit.
What are the types of debt consolidation?
There are three common types of debt consolidation.
- Credit card balance transfers arise when you open a new credit card and then transfer debt from various existing accounts to that card.
- Debt consolidation loans offered by a bank or credit union can be used to pay off a debt. You then have to repay the loan every month.
- Credit counseling services work with you to tailor a solution to your specific debt problems. These services typically work with your creditors to negotiate lower payments, then make those payments with a fee that you pay them each month.
What are the advantages of debt consolidation?
Debt consolidation can have a number of benefits, the simplest of which is that the number of payments you need to make each month is reduced to one, simplifying the payment process and making it easier to track your debt. You’re also much less likely to forget an account and miss a payment since you’ll only have one to remember.
Additionally, debt consolidation can lead to lower interest rates, which means more of your payment is used to pay down the principal of the debt. This will help you pay off the debt faster.
Another benefit is the potential improvement in your credit score. Since the rate of credit utilization is a determining factor in determining your credit score, consolidating debt into a personal loan, for example, will have a positive impact on your credit score. Also, the faster you pay off the debt, the better your credit rating will be.
What are the risks of debt consolidation?
As with any financial decision, make sure you have all the information and read all the fine print before agreeing to a debt consolidation strategy. Some debt consolidation counselors are actually scams with high fees and interest rates that end up hurting your financial situation rather than helping it. If you’re considering consolidation, make sure you’re getting the best product by shopping around and comparing interest rates, loan terms, and fees.
For example, even if your interest rate goes down, if you pay off a debt over a longer period, the total interest you pay could be higher than in your current situation. Be sure to work with a reputable institution and do your research to ensure that the actions you are taking are truly in your best interest.
Finally, no financial maneuver will help you if you regularly spend more than you earn. When considering debt consolidation, you must first look at your expenses, create a budget, and cut back where you can. Debt consolidation will not solve existing financial problems that result from irresponsible spending. Debt consolidation in the right situation and on the right terms can be a useful tool for paying off debt. By having everything in one place, you can simplify your payments and pay off your debts faster. However, you should use these tools with caution and always do proper research before making any important financial decision.
Finance FYI is presented by 1st Security Bank.
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