Smart Spending

Using Debt Consolidation to Lower Your Borrowing Costs

Debt can quickly become a major problem when you have a number of different creditors to whom you owe money.  Not only is keeping up on all of the different monthly payments a hassle, but the combined monthly payment may stretch your budget to its breaking point.  When you have high interest debt, or multiple debts that you owe to different creditors, debt consolidation may be your best option.

Understanding Debt Consolidation

Debt consolidation is the process of borrowing money to pay off other debt.  The idea is to get one new loan that has better terms and that is, ideally, going to be easier to pay and cost you less to pay off in full.  The new loan will pay off old loans that you have that have high interest rates or other terms that are making it difficult to pay.

Types of Debt Consolidation

Debt consolidation takes many forms.  One type of debt consolidation involves consolidating your student loans.  Special programs from the Department of Education and other loan providers give you the opportunity to lock in a lower interest rate and get a more flexible repayment schedule.  For instance, when you consolidate with the Department of Education, you may be able to use an income-based repayment plan where your payments are set to equal a percentage of your income.

Debt consolidation can also be done for other debts. You can consolidate debts by taking a special debt consolidation loan, but these often have prohibitively high interest rates.  You can also take a standard personal loan and use it to repay debt, or use a balance transfer offer from a credit card company to combine multiple other debts under one and to take advantage of a low promotional interest rate for a period of time.  A final option is to tap into the equity in your house using a home equity loan and use the proceeds from this loan to pay off debt.  This option can allow you the lowest interest rate since a mortgage typically charges significantly less interest than credit cards.  However, this option is risky because your home because collateral, essentially changing unsecured debt into secured debt.

Is Debt Consolidation Right for You?

Whether or not debt consolidation is right for you will depend upon your financial circumstances.  The first question to ask is whether you can qualify for a loan to use to consolidate your debts.  You’ll typically need good credit in order to get a loan that actually offers better rates than what you have.  If you want to tap into home equity, you’ll also obviously need to make sure you have equity in your home.

If you are able to qualify for a new loan, you’ll need to make sure that you can pay it off and that it makes financial sense to transfer the debt onto this new loan. Consider what your new interest rates and monthly payment will be and compare that to what you are currently paying to see how much you will save.  Don’t forget to include any fees for applying for the new loan.

If you are going to be saving money by consolidating, it can be a good idea to go ahead and do it.  Make sure to understand what the repayment terms are first.  If you consolidate using a credit card balance transfer with a low promotional rate, you might be offered a low interest rate for a year.  You’ll need to find out if you can actually pay off all the debt you are consolidating during that one-year period.  If you can’t, what does the interest go up to?

Finally, you need to consider whether you can be responsible with your money after the consolidation.  If your spending is out of control, there is a chance that the cards may get charged up again, leaving you with all of the old debt to pay off in the consolidation loan plus a lot of new debt that will also have to be dealt with.

If you are committed to paying off your new loan, if it will save you money and if you are going to stop incurring new debt, then debt consolidation may be a great thing for you.