If you are trying to get out of debt, a debt consolidation loan is a strategy to consider.
Debt consolidation involves combining several debts into one debt. In addition to a debt consolidation loan, here are some other popular ways to consolidate debt:
There are a lot of pros and cons to debt consolidation as well as many myths surrounding the subject. Before you go ahead, let’s shatter a few of these myths that might affect your decision.
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Myth # 1: Debt Consolidation Repays Less Money
Debt consolidation is not debt settlement. In a debt settlement, the consumer negotiates an agreement to pay back less than what he owes. If it sounds too good to be true, that’s because it usually is. Debt settlement can take a long time. This can seriously damage your credit score and cost you additional money in taxes and fees. Also, there is no guarantee that you will ultimately pay less than what you would have paid without the settlement.
Debt consolidation does not change the amount of your balances. You simply take out a larger loan to pay off several smaller debts.
Myth # 2: Debt Consolidation Hurts Your Credit Rating
Every time you apply for credit, your credit rating may drop a few points. When you apply for a debt consolidation loan, there is no rate buying window. Each request will create a new inquiry on your credit report, and each has the potential to lower your score a bit.
Having said that, the debt consolidation loan by itself does not hurt your credit score. Here’s why.
Your credit score is based on:
- Your payment history
- Your credit utilization rate – how much you owe on your credit cards against limits
- Your credit mix – the different types of credit you may have (credit cards, installment loans, mortgage, etc.)
- The age of your credit accounts
- The number of times you have applied for new credit recently (requests)
In some cases, a debt consolidation loan can actually increase your credit score. This is a common finding for people who use this type of installment loan to pay off their credit card debt. When you pay off your cards, your usage rate goes down because it’s calculated on your revolving debt, not your installment loan debt. Usage is a big factor in your credit score, so paying off your cards could boost your score significantly.
Also, if you did not have an installment loan on your credit report before, your credit composition will improve when you get the debt consolidation loan. It could also increase your credit score.
Myth # 3: Debt Consolidation Takes Time
Debt consolidation is not a long process. If you qualify for a debt consolidation loan, you can consolidate your debt within days. Factors that affect the schedule include:
- It’s time to research loan options
- Whether you qualify now or need to improve your credit score first
- How quickly the lender processes and approves your request
- How long it takes to receive the funds (usually the same day or a few days after approval)
Myth # 4: Debt Consolidation Is Expensive
Debt consolidation is not free. Most lenders charge a setup fee or a lender fee. Those who don’t usually charge a higher interest rate.
Even so, many people reduce their overall cost when consolidating their debts. Indeed, the interest rate of a personal loan can be lower than the average interest rate of the debts that you want to consolidate. This is especially common if you currently have credit card debt.
As long as you research consolidation loans and their fees carefully before choosing one, debt consolidation can be a smart solution to paying off your debt.
Myth # 5: Debt Consolidation Means More Debt
One of the most dangerous pitfalls of debt consolidation is increasing your overall debt. This can happen when you use a loan to pay off your credit cards and then top up the credit cards.
Only you can break this myth.
Yes, if you pay off your credit cards with a new loan, you will have the potential to take on even more debt. But if you have a solid financial plan, increasing your debt load is far from inevitable.
A great solution is to close your credit card accounts as soon as you pay them off. Don’t worry about it hurting your credit score. On the one hand, getting out of debt is more valuable than protecting your short term credit score. For another, the damage is probably minimal. You might lose some points if your account age decreases, but you will earn points when your usage rate decreases.
The advantages of deleveraging far outweigh the disadvantages of temporary fluctuations in your credit rating.
Before applying for a debt consolidation loan, take a step back and assess the reasons why you are in debt. For many people, debt is the result of a financial situation that was not under their control. But sometimes debt can be the result of overspending or not having the right budgeting method in place. No matter what category you find yourself in, you will get the most out of debt consolidation if you combine it with a plan for managing your personal finances.