Using debt consolidation loans to get out of a difficult financial situation is a common practice. In fact, this seems to be the most logical way to get out of debt for someone who has no idea about the other debt relief options available. A consumer who has not heard of debt settlement, debt management, credit counseling and other debt solutions will most likely think of using a loan to get out of their other credit obligations.
Some people think that using a loan to solve your existing debts is just like digging a hole to fill another hole. While that analogy may be true, this type of debt solution is actually quite effective – at least, if you know how to use it properly.
Debt consolidation loans are typically used to combine credit accounts with a high interest rate (e.g. credit card debt) and those with a low interest rate (e.g. home loans).
This type of solution is actually ideal for those with multiple high interest rate debts because it can help lower the current interest rate. The perfect example is credit card debt. According to an infographic published on PressPage.com, the average credit card debt of American consumers is currently at $5,142. This is based on the data gathered by TransUnion for the first quarter of 2015. If the average interest rate of this type of debt is 11% to 15%, it would mean paying as much as $64 per month on interest. That is a total of $768 each year. You are paying your creditor that much amount – the longer you stay in debt.
With debt consolidation loans, you have the chance to lower your interest rate. What you will do is to look for a new loan that you can get with a lower interest rate. In some cases, people use their home as collateral so they can get a secure loan. Since the risk is lesser because of your collateral, the creditor or lender will give you a low interest rate on this new loan. You can use the funds from this new account to pay for your existing debts.
In most cases, debt consolidation loans have a longer payment term. It stretches your current balance so you have a lower monthly payment.
All of this will result to a lower interest rate, a possibly lower monthly contribution and a longer payment term. This will help make debt payments more manageable because you have more room in your budget – now that your monthly payment is lower.
What are the two possible outcomes when using a loan to consolidate debt
Although this debt solution sounds promising, you need to be very careful when you choose to use it for your debt relief option. According to an article published on Time.com, it is very important that you understand how this debt solution works. There are fees, rates and other financial implications that you may not be comfortable with. If you are using your home as collateral, you might not be prepared for the risk that you will be putting it through. Like all debt solutions, there are two ways that your debt relief efforts can go. If you are not strategic about your use of debt consolidation loans, you might do more damage on your personal finances.
Let us discuss the best and worst case scenarios that can happen to you when you choose to use debt consolidation loans.
Best case scenario: You get out of debt.
Obviously, the best case scenario is your debt freedom. If you do things the right way, you should be able to get yourself out of debt.
This scenario involves being approved for a low interest rate loan. That way, you can save money on the interest amount that you have to pay for the convenience that the loan will bring. To arrive at the best case scenario, you also have to search for a loan that will not involve a lot of fees. The loan should also allow you to make lump sum payments whenever you are able. It should not charge you with prepayment penalties. That way, you can get out of debt a lot faster without incurring additional charges.
Another way to get to this scenario is by having a good credit report. The only way you can get the best possible terms on this new loan is when you have a high credit score. Having collateral will allow you to get a low interest rate on their loan, it is true. But it is a good credit score that will really help you get the best terms for your debt consolidation loan.
Worst case scenario: You add more into your debt.
Now to the worst case scenario – it is obviously ending up with more debt than when you started. This will happen if you get a loan that has a high interest rate and you fail to pay it on time.
The high interest loan is only possible if you have a good credit score. But even that can be saved if you only learn how to pay off your loan on time. You see, when you put all your debts and combine them into one loan – there is great danger in that. Some people get a false sense of complacency. They feel like they have already gotten out of debt.
Well, debt consolidation loans will not pay off what you owe – at least, not yet. You just transferred your multiple loans into one basket. You still have to pay them off. Some people make the mistake of thinking they already got out of debt. It made them more inclined to get more debt.
That is how you can land in this worst case scenario – and end up with more debt to your name.
How to assure that consolidating debts will work in your favor
But since you know the best and worst case scenario, you know what you need to target. You need to know how you will land in the best case scenario – not the other way.
According to Investopedia.com, if you do debt consolidation loan correctly, it can really boost your financial situation. It can improve your credit score – at least, if you pay off the principal a lot faster.
To help you accomplish that, here are some things that you can do.
- Keep yourself from feeling complacent. As mentioned, you still have to pay off your loan. You need to remember that you just transferred your balance. You still have to pay for every penny. There is no debt reduction in this type of debt solution.
- Refrain from borrowing more money. We are not saying that you stay away from debt entirely. You need to take on credit in order to keep your credit score up. However, you need to learn how to borrow money wisely. That way, even if you take on more credit, you will not endanger your finances in any way.
- Stick to your new payment plan. Lastly, you want to make sure that you will stick to your new payment plan. Forget about the old payment schedules of your multiple debts. Concentrate on this new one and try to pay it off diligently. That is the how you can be sure to get yourself out of debt.
Debt consolidation loans will effectively eliminate debt as long as you avoid the traps that can lead you to the worst case scenario. All it really takes is some self control, discipline and better financial habits.
