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Debt consolidation is something that you may be considering if you have debt coming from multiple places. The idea behind debt consolidation is that if you put all of your debts in one place they will be easier to pay off. The pros of debt consolidation are that you have one bill with one interest rate that you pay on one due date. However, the issue with putting all of your eggs in one proverbial basket is that if you miss one payment, the consequences are much greater.
How does debt consolidation affect your credit?
When you consolidate debt, your credit score will go down a bit temporarily. This is because the consolidation will trigger an inquiry into your report. This decrease, however, is temporary. In fact, your debt consolidation has the potential to increase your credit score in the long term if you make consistent payments. Payment history makes up 35 percent of your credit score. Making sporadic payments, or worse, missing payments, is a quick way to destroy your credit score. However, making consistent payments on a debt consolidation loan can begin to push your score back up and show that you are making an effort to deal with your debt.
How much does debt consolidation hurt your credit?
Debt consolidation has the potential to be very positive for your credit, but if not handled well it can also have the opposite effect. That’s because putting a large sum of debt on to one loan will likely affect your debt-to-credit ratio, or credit utilization. Your credit utilization makes up 30 percent of your credit score. When your debt-to-credit ratio is in the 10 to 30 percent range, this factor has a positive effect on your credit score. However, when you consolidate debt and put a large sum on one credit line, possibly maxing out that credit line, your ratio will be considerably higher, having a negative effect on your credit score. As long as you are making consistent payments on your debt consolidation and not making new debt, this drop in your score should be temporary.
Your credit rating is not just about your credit score, though. It looks at other factors like income, job stability, and ability to use dormant credit lines. Consolidating your debt will take certain lines of credit out of your credit mix. This will have an effect on your credit rating. However, that is only one factor in your credit rating. If you have a steady income from a stable job, your credit rating will be able to stay in a good place and you’ll also be in a good position to pay off your debt sooner.
Consolidating debt with a balance transfer
One way to consolidate a debt is through a balance transfer card. If you have a good credit score, getting a balance transfer card can often prove easier than getting a personal loan. With a balance transfer card, you are essentially transferring your high interest credit card debt to a card that will offer you a lower interest rate. Many balance transfer cards offer introductory zero percent APR periods. The important thing to note here is that the rate is only for a limited amount of time.
If you are planning to go the balance transfer route, it is essential to pay off the debt during the introductory period. This means that you need to have a solid repayment plan for how you will do that. It also means that you need to stay away from creating new debt. Keep in mind, too, that balance transfers are not free. Most balance transfer cards will charge a transfer fee that is usually between 3 and 5 percent of the amount you are transferring over.
Consolidating debt with a personal loan
Getting a personal loan through a bank or a credit union is another way to consolidate your debt. The better your credit score when you apply for a personal loan, the better chance you have of not only getting a loan but also securing a lower interest rate. A personal loan will be paid out in a lump sum. In order not to create more debt for yourself, make sure you request the amount you need to pay off your debt, no more, no less. Once you have your loan, you’ll need to distribute the money to your current lenders to pay off your debts. If you are dealing with credit card debt, you will also need to decide whether you will close your accounts or keep them open. It’s usually a good idea to keep one or two accounts open to keep your credit history intact.
After you’ve distributed the loan money to pay off your debts, it’s time to work towards paying off your loan. Loans will have a specific time frame for repayment that can be anywhere from one year to five years. It’s important during this repayment time that you keep any new debt to a minimum. Focus your efforts on repaying your loan. A personal loan is a kind of unsecured debt, which means that you won’t lose anything if you miss a payment. You will, however, see that missed payment affect your credit score. If you feel your monthly payments are out of reach, you can ask for a longer repayment period to lower them. Just know that a longer payment period means more time for interest to accrue on the loan.
Other ways to consolidate debt
Take out a home equity loan
This is a kind of secured debt that allows you to take out money against the value of your home. It usually has low fixed interest rates, between 4 and 12 percent. The interest is usually tax deductible, which is a bonus. Home equity loans also have longer repayment periods, sometimes up to 30 years. This means you will have lower monthly payments and more time to pay off the debt. The specific terms of your home equity loan will depend on a variety of factors, including the equity in your home and your credit utilization ratio. The obvious con to this kind of debt consolidation is that you are putting your home at risk. If you default, you could be looking at a foreclosure.
Borrow against life insurance
This is a good option to pay off smaller debts. You can borrow up to the cash value of the policy and there’s no mandate to repay it. Of course, if you don’t repay it you’ll lose your death benefits in the amount that you borrowed. If you have enough accumulated in the policy and don’t foresee needing it anytime soon, this could be a good option. However, you’ll be losing a bit of peace of mind as far as being able to take care of death expenses if the worst were to happen.
Borrow from retirement/401k
If you are far from retirement or can afford to have money taken out of your check, this is an option for you. Policy rules will apply and you’ll likely only have access to a certain percentage of your money. This kind of loan also has a specific time frame for repayment, and you may have to pay it back with interest. Before making the decision to use these funds, it’s a good idea to talk to your benefits administrator to weigh all of your options.
Despite all the rules, borrowing this way is easy because you are essentially borrowing from yourself. There’s no application process and no credit check. An obvious con, however, is that you are putting your retirement money on the line. If you don’t pay it back, you may be looking at working a few more years than you had planned. Not paying it back may also result in taxes and penalties, since 401k payments are considered income.
In order to begin this type of program you need to be able to demonstrate a level of income that will cover your monthly bill payments. You’ll be partnered with a debt counselor to help you develop a budget to ensure you can make consistent payments. Your plan will likely have you make monthly lump sum payments to your debt management firm that will be distributed amongst creditors until your accounts are paid off. When an account is paid off, your debt counselor will close that account. Debt counselors will negotiate your payment plan with your creditors, but there’s no guarantee that creditors will agree to the plan. If, however, you creditors do agree, you can’t miss any payments. Missing payments may invalidate the whole repayment agreement, which will put you back at square one with your debt.
Debt settlement and bankruptcy
These two options are also ways to deal with debt, but they are basically for those that are at the end of the road. Both of these options have serious consequences and should only be considered when other options have simply not worked. Debt settlement is a complicated process that involves negotiations with your creditors to pay less than the debt you owe. Bankruptcy is even more complicated, but will essentially put all of your assets up to pay for your debts.