Debt consolidation is when a borrower—let’s say, you—chooses to combine multiple debts, such as credit card debt and high interest loans.
These individual debts are rolled into a single debt—usually a loan—with one monthly payment. Typically, you would consider making this move for more favorable payoff terms, such as reduced interest rate, a lower monthly payment, or both.
Here’s a simple breakdown of the concept.
How Debt Consolidation Works
Debt consolidation can seem like an intimidating concept, but it can actually be explained as easily as one, two… three.
Step 1. First, you apply for a debt consolidation loan through a bank, such as Sunrise Banks, or another financial institution.
Step 2. Once approval for the debt consolidation loan is finalized, the next step follows one of two paths: Either the lender can pay off your other debts directly or you can use the funds to pay off your outstanding balances yourself.
Step 3. After these initial debts are paid off, you will then make a single payment on your new loan each month.
Let’s imagine you have three credit cards with the following balances:
- Card A: $4,500
- Card B: $10,900
- Card C: $7,800
The total credit card debt is $23,200 with an annual percentage rate (APR) range of 11% to 26%. If your credit is good—or perhaps your credit score has improved since you first applied for these cards—then let’s say you qualify for an interest rate of 7% on a consolidated loan. Over the term of your loan, that could save you a good chunk of money. Or, perhaps you’re able to secure a loan with a locked-in interest rate of 8%—that still saves you money.
In addition to a debt consolidation loan, another way to consolidate is through a 0% interest, balance-transfer credit card. Each of your individual debts will be transferred onto this credit card and you will pay the balance in full. With this option, you will need to have good credit to be approved.
Taking out a home equity loan or a 401(k) loan are two additional options for debt consolidation. If you agree to take on one of these options, however, you are also agreeing to take on some risk—either to your home or your retirement.
When Might Debt Consolidation be a Good Option…or not?
Keeping track of and making payments each month to multiple lenders can be more than just a hassle—it can be harmful to your credit (and your sanity) if not handled effectively. If any of your debts have a high interest rate, it’s possible that a consolidated loan could save you money. And depending upon your specific situation, there’s a chance that the convenience of having only a single payment to worry about each month is priceless.
That being said, consolidating your debt won’t solve all of your financial woes. Making only minimum monthly payments, for instance, will allow debt to accrue regardless of the loan terms. Also, if there are bad habits at play such as over-spending, rolling individual debts into one loan will only be as effective as putting a Band-Aid on a broken leg.
If you choose to consolidate good, low-interest debt, it’s possible you won’t end up saving money. And when consolidating privately, you may lose certain benefits to your individual loans—such as federal benefits on student loans. These are just a few of the details to take into consideration when balancing the pros and cons of debt consolidation.1
Additionally, as you think about whether debt consolidation makes sense for you, taking a look at your “good” debt versus “bad” debt may be helpful. Good debt includes low-interest loans such as student loans, mortgages, and small business loans. Bad debt includes credit card debt and loans for splurges like expensive vacations or other purchases that could contribute to living above your means.
Discover More with Sunrise Banks
Debt consolidation is just one of the many financial topics that Sunrise Banks can help you tackle. From budgeting and homebuying to investments and retirement, check out the resources available in our Personal Finance Knowledge Center.
1) This post is for informational purposes only. As individual circumstances vary, please research available products to ensure your needs are met.