How Does Debt Consolidation Work?

How much debt do you owe? Debt consolidation is a proven method you can use to cut down on your credit card debt or student loan fast.

Unfortunately, it is ignored by many people out there due to lack of sufficient information or misinformation.

Debt consolidation involves merging a number of high interest and risky debts into one with lower interest rates and favorable payment terms.

When done the right way, it can save you a lot of money and improve your credit score a great deal in both short and long term.

You also get the privilege of paying half the interest charged by the credit card companies and lower monthly deposits terms while clearing your debt within the same time frame or even shorter.

So, how do you go about it?

Here is a 5 steps guide to help you consolidate your debt the right way.

Step 1: Get to know your debt situation

The first step when consolidating your debt is to know your debt situation well.

A clear picture of your debt situation in relation to other life goals will allow you to plan well and arrive at the best debt consolidation plan that works for your unique situation.

There are a few parameters you have to keep in check when analyzing your debt situation. Given every debt is unique (to the person) depending on the prevailing circumstances, these parameters will allow you to settle on the best debt consolidation option with ease.

Your debt balance

While analyzing your debt situation, getting to know the amount you have to pay is very important.

How else will you start planning when you don’t know exactly how much you owe your creditors? You therefore have to know the debt balances in all your credit cards and any other high interest miscellaneous debt.

However, if the balance is credit card only, you have to remember it is influenced by a number of factors including prevailing market interest rates. When they increase, you will have to pay more. When they go down, you will end up paying less.

In case you fail to pay it within stipulated times you will accrue penalties.

Interest rates charged

The interest rates charged on your balance determines how much you will have to pay in the end.

A higher interest rate typical of credit cards means you will have to pay more money in the end.

You will therefore need to get the interest rates charged in all your credit cards and other debts then compute the average. The average interest rate you get will guide you when choosing the best debt consolidation plan that will work for you.

You will know the interest rates you should target when consolidating your credit card accounts.

Repayment dates

You have to keep in mind the due dates for your credit card debts. Keep meeting your monthly obligations until your consolidation plan is confirmed.

Often, as soon as you start the debt consolidation process, most people neglect their debt payments even before they get confirmation from the consolidating partner.

Such a move attract a late payment penalty that adds up to the huge balance you already owe.

You should therefore keep on meeting your obligation with the lenders and creditors until you get an approval or until when you are so sure that you consolidation plans will go through.

Credit account terms

Lastly, you will need to revise your credit cards payment terms. If you are not so sure or even conflicted, visit them or give them a call to discuss the payment terms and conditions.

Take note that some companies impose prepayment penalties (fees) for all accounts that pay upfront.

This could work against you in that consolidation involves paying all your fragmented debts at once.

Talking to your company will help you clear such. If they impose prepayment penalties, ask for ways to avoid it without incurring other penalties.

To this far, you have detailed clear understanding of your debt situation. You can now proceed to the next stage.

Step 2: Find how much you can pay

At this stage, you are assessing your ability to pay. Given that debt consolidation involves getting a cheaper debt with favorable terms and use it to pay a more expensive debt, you will need to know your financial position and capabilities.

Check how much money comes in and what portion of it can you comfortably allocate to repaying the new loan.

This will go in hand to help you in deciding the right debt consolidation plan that will work for you.

 Here are a few things you will have to keep an eye on when scrutinizing your financial flow.

Income

Your income is where you will get the money to pay off the consolidated debt. You will need to calculate the amount of money you get every month. Also determine the stability of the sources of your income.

If your income sources are unstable, then you will need to devise a plan that will work for it.

You will have to allocate enough to meet your current payments and the remaining should go to your emergency fund account.

You will need it at the time when your sources of income become unstable and not sufficient to your debt payments.

Expenses

After looking at your income, you will need to check on your expenses.

Your expenses need to be guided by a budget in the first place.

You will have to exclude all your debts given that consolidation will solve them. List all you need to live well and allocate the minimum spending needed for each of them.

Subtract these expenses from your income and you will have the deposable income. This is the amount you should allocate towards paying your debt.

If it does not fall within your expectations, you will have to balance your budget again until it just fits.

Be as realistic and practical as you can in that you don’t end up trying to live miserably and end up breaking your budget.

Emergency fund

After accessing your income and analyzing your expenses, you will have to look at your emergency fund. An emergency fund comes in handy when the going gets tough financially.

If you don’t have a well-stocked emergency fund, commit large amount of your disposable income towards building your reserves first. A well-endowed emergency fund will help you in the times of uncertainty and you will not have to compromise on your debt payments.  

Insurance

Lastly, make sure you have goal insurance in place working for you before you think of paying debts.

If your children are getting to school or you plan to get more education, have an insurance plan in place working for you.

You can never go wrong with goal insurance. All you have to do is to identify what you want to achive, shop around for the best policy and commit to it. When the time comes, you will achieve your goal more easily, given that the financial aspect of it will have been sorted.

Note; while it is general consensus that you pay as much as you can towards clearing your debt, do not commit all your disposable income. Allocate the bare minimum towards debt and commit the remaining towards other financial and life goals like building your emergency buffer, saving for mortgage down payment or even get an education policy for yourself and your children’s future.

Step 3: Review your post-consolidation financial goals

At this point, you have a clear understanding of your debt and financial flow.

It is time to look at your other financial goals and make sure they align to your debt consolidation strategy.

Your debt consolidation strategy should not stand in the way for your other financial goals. Your other financial goals too should not hamper your debt repayment strategies. This step involves clearing your debt and in a way that least hurts your finances and financial goals.

Most of the methods you choose to consolidate your debt involved incurring a new debt. However, the new debt will be cheaper with lower payment terms compared to the original debts.

Given that you will have to get a new bigger loan first and use it to clear all your high interest credit card debts, your credit score scores will temporarily go down. This will in return affect your chances of getting cheaper loans in the short term.

If you have been saving for a holiday and would like a credit card to bump it up, then you should postpone debt consolidation.

Also, if you have been eyeing that down payment for your new home, you should shelve debt consolidation idea until when this is done.

These are just a few examples when your debt consolidation plans have to be aligned with your short term and long term financial goals.

Step 4: Research on consolidation options

Up to this stage, you have all the information you need to make a smart choice of the best debt consolidation plan.

The choice you will arrived at should conform to your finances and future goals (both life and financial).

The target here is to lump all your fragmented debts into one in the process called debt consolidation.

The resulting consolidated debt should be manageable, cheap, with lower interest rates and lower payment terms compared with the average rate for the previous debt.

 Here are the options you can take.

#1. Debt consolidation loans

Debt consolidation loans involves taking a loan from a financial institution (bank, credit unions) and use it to clear all your credit card and other high interest debts.

You therefore remain with only one big debt as opposed to several fragmented ones (let’s say from 3 credit cards).

Most often, the interest rates charged for the loans are way lower than the average charged by credit card companies. The amount you will have to pay monthly too will be lower and terms flexible enough for you.

These loans can either be secured or unsecured. The secured loans mean you have attached an asset in that if you default your payments, the banks will take your assets to compensate for the loan.

However, even when you don’t have any assets, you still qualify for unsecured debt consolidation loans. You have to have good credit scores if you want to secure lower interest rates.

Make should to compare different lenders and only sign for the lowest rates and best terms available.

#2. Zero interest credit balance transfer

Some credit companies offer 0% balance transfer to attract new consumers. This means you will not be charged interest for the specified period of time if you sign up and transfer your balances to the new card.

As a strategy to consolidate your debt, you can transfer your debt to the new card. Thereafter, you can use the window of opportunity to maximize on your debt payment. By the time they start charging interest on your balance, you would have cleared a larger part of our debt.

Remember, while shopping for such credit cards; make sure to look for the one with the longest grace period. This will give you enough time to work on clearing your debt. By the time interest kicks in, it will get you at a position of strength.

#3. Debt management (credit counselors)

This method involves an expert. You will get assigned a credit counselor who will help you craft a new debt management plan than best suites your financial situation.

The plan will have a new repayment schedules.

The counselor will then present it to your creditors and negotiate for favorable terms. If there are any new adjustments, you will be informed. If you agree with it, a new account will be set for you.

You will make specified monthly (negotiated) payments to the credit management company and they will take care of the rest for you.

You have to make ensure the company you are working with is trustworthy. Do enough research; check their reviews online before you decide to settle on one.

Step 5: Start crunching your debt

At this point, you will have chosen your desired debt consolidation strategy that works for your credit situation. Every person’s situation (debt and financial situation) is different and unique.

Therefore, the choice you settle on should not only reflect your financial situation, but also accommodate your personal preferences.

If you intend to use your credit card soon, you should avoid credit card management. It freezes up all your credit cards until all debt is paid.

Those privileged to have high value assets can use it secure low interest loans (like home equity loan) and use it to free themselves from the debt trap. Make sure to clear the loan within the stipulated time frame or you risk losing your property to the lender.

If your credit card balance is low and can be cleared in a few months, getting 0% balance transfer cards and transfer you credit card debt balance to the new one will be beneficial. It will give you time to clear the remaining balance fast before the new card’s interest rates kicks in.

In the meantime, how often do you monitor your credit scores? You can monitor your credit score here free. Check it out now.  

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