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Debt consolidation is a powerful tool that could help you become debt-free quickly.
You can use debt consolidation to pay off your high-interest debts and save on interest payments. If you like to be debt-free sooner, this guide is for you.
We will walk you through debt consolidation, how it works, and whether it is the right option.
Let’s start with your first question:
Debt consolidation means paying off high-interest debts using a lower-interest loan.
For example, suppose you have the following debts
It will consolidate these debts into your mortgage loan. Mortgage interest rates are lower than interest rates of unsecured debts. By reducing these high-interest debts into your mortgage, you will save on interest payments, relieve your monthly financial burden and overall, live a happy life.
Many people can barely meet the minimum monthly payments on all their debts, meaning that it will take a very long time to get out of debt and pay a lot of money in interest charges.
Worse still, high-interest debts can spiral out of control and become unmanageable.
If you have high-interest loans, debt consolidation can have many benefits. The lower interest rate means that the debt becomes more manageable, you pay less interest, and you may get out of debt faster.
Many people find that direct payment reduces the chance of forgetting to make a payment and incurring late fees or additional charges, which could plunge them into debt.
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If you are a homeowner, you will likely find that your mortgage has the lowest interest rate among all your debts, making it the most sensible option for debt consolidation.
But there are essential considerations to bear in mind.
But here’s the big one.
So you need to carefully review the benefits of consolidating with the risk of overstretching yourself and being unable to make the mortgage payment.
The bottom line is that while debt refinancing is a powerful tool, it should be reserved for the highest interest debts where the risk/return payoff is most significant.
There are several potential pros and cons of debt consolidation. Let’s summarize some of the key advantages:
A lower interest rate means more of your payment goes towards the principal, and less is wasted on servicing the loan. If you can refinance your mortgage, or your credit score has improved since you took out your other loans, you may be able to decrease your overall interest rate by consolidating debts. This could save you money over the term of the loan.
Consolidating your debts into a lower-interest loan could significantly reduce your monthly payments, especially if you consolidate by refinancing your mortgage. This may substantially benefit your monthly budgeting and help you get the rest of your finances into better shape.
Having several loan payments to make each month can lead to anxiety and the feeling that everything is getting on top of you. Simplifying your loans into one payment can help relieve this stress and make you feel you’re back in control.
It could take decades to pay off if you’re only paying the minimums due on your consumer debt. Most debt consolidation loans (especially mortgages) have very clearly defined payment schedules, so you can see exactly when you’ll have the whole debt paid off.
It could reduce late fees and improve your credit score.
The more payments you have to make, the higher the chance you will forget one of them. This could lead to additional charges, putting you even further into debt.
But it can also damage your credit score. Having one payment means you’re less likely to miss it, and you’ll not only avoid late fees but gradually improve your credit score.
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Of course, nothing in life comes without a tradeoff. So let’s take a look at some of the cons of debt consolidation:
If you consolidate your debts by refinancing your mortgage using a 4- or 5-year term, you may take longer to pay off the debts than if you had not consolidated.
You’re putting your home on the line.
If you consolidate your debts by refinancing your mortgage, it’s essential to consider that your home will be collateral against your debts. If you default on your refinanced mortgage, you risk foreclosure.
Debt consolidation can be an excellent solution to debt, but it doesn’t address the underlying bad financial habits that created the debt in the first place. Debt consolidation can clear credit card debt, but the debt hasn’t gone away. It’s just been transferred to a different loan. So if you don’t change your spending habits and stop accruing new credit card debt, you may find yourself in even deeper debt after consolidating.
In addition to refinancing your mortgage to consolidate debt, a couple of other options are available to homeowners.
A HELOC is a line of credit secured by your home. HELOCs allow you to access up to 80% of your home’s value, minus your current outstanding mortgage balance. HELOCs typically carry a slightly higher interest rate than a standard 5-year variable mortgage rate.
The difference between a HELOC and a regular mortgage is that a HELOC is a revolving line of credit. So instead of advancing you a fixed amount of money, a HELOC lets you draw money as you need it. This makes them more flexible than a regular mortgage.
Your minimum monthly payment is an interest-only payment determined by how much you withdrew. You can typically pay off the loan as quickly as you like without any overpayment penalties. So as your financial situation improves, you may choose to pay off your HELOC faster and get out of debt sooner.
The other advantage of a HELOC is that you will not have to pay refinancing penalties for breaking your mortgage contract.
If you struggle to qualify for a larger loan with your existing mortgage lender, you could consider taking out a second mortgage with another lender. Bear in mind that the interest rates offered are likely to be significantly higher than your first mortgage (although still lower than credit cards and personal loans), so you should weigh up carefully the advantages of debt consolidation using a second mortgage.
You may find that once you have considered the interest rate and the fees of a second mortgage, it only makes sense to consolidate your debts with the highest interest rates.
The high-interest rates of consumer debt, such as credit cards, auto loans, and personal loans, can make breaking out of debt very difficult. It could take years or even decades to become debt-free if you can only meet your minimum monthly payments.
Debt consolidation can be an effective tool, helping you reduce your monthly payments, incur less interest, and simplify your finances, helping to avoid missed payments and improve your credit score. Above all, it can give you a light at the end of the tunnel.
There are, of course, downsides and things to consider before committing to debt consolidation through mortgage refinancing. Taking out a 4- or 5-year mortgage to consolidate debts might mean that if you don’t make overpayments, it takes you longer overall to pay off your debts than if you hadn’t consolidated. And as your home will be the collateral against your debt, you risk foreclosure if you fall behind on mortgage payments.
While it initially may seem counter-intuitive to pay off debts using another debt, debt consolidation may be a highly effective approach in helping you become debt-free.