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How to Consolidate Debt

To say that American household debt has reached epic proportions might be an understatement. Auto, student loan, credit card and mortgage debt levels are on the rise.

The year 2018 closed with American households holding a record $13.54 trillion in debt, according to the Federal Reserve Bank of New York’s Center for Microeconomic Data (CMD). Auto loans spiked by $9 billion, student loan and credit card balances grew by $15 billion and $26 billion, respectively.

While home equity lines of credit (HELOC) balances were at their lowest levels in 14 years, total debt at the end of 2018 was $869 billion higher than the previous milestone of $12.68 trillion reached in Q3 of 2008.

Source: New York Fed Consumer Credit Panel/Equifax

The last quarter of 2018 saw America embrace $401 billion in newly-minted debt. It appears that younger Americans between the ages of 18 to 29 accumulated a significantly higher proportion in student loans, credit card debt and auto loans.

The report also shows that 68,000 individuals had new foreclosure notations added to their credit reports during the quarter, with 11.4% of student loans flagged as 90+ days delinquent or in default.

What’s worrying for America’s economy is the fact that Q4 2018 was the eighteenth consecutive quarter in which aggregate household debt has steadily climbed.

The only way out of this quagmire is to face debt head-on to eliminate or significantly reduce it. Debt consolidation — a process of combining multiple debts to make managing and discharging debt easier — is one strategy you can use.

Step 1: Take Stock of Your Debt

Debt consolidation is about getting a handle on a bad situation, and it’s hard to take control of any situation unless you know what you’re up against. Before you make any decision about debt consolidation, it’s important to understand the following:

  • Who you owe money to? Credit card companies, student loan providers, mortgage lenders or car dealerships?
  • How much do you owe to each?
  • What interest rates you pay?
  • How often are payments due?
  • When is the exact date each payment is due?
  • What credit terms are associated with your debt? What are the minimum payments, missed payment penalties and prepayment penalties?

While consolidating and paying off multiple debts through a single loan, you may end up pre-paying some of your debt. Knowing the credit terms of such debt will help you understand the impact on your financial situation of any proposed debt consolidation plan.

Step 2: Take Stock of Your Financial Position

Debt consolidation isn’t the same as debt forgiveness — you’ll still need to pay off your debt! The next step in your debt consolidation strategy must be to understand your current financial position.

  • How much money do you earn?
  • How frequently are your income streams producing cash flow: Weekly, monthly, several times a year?
  • What are the sources of your income: Salary/wages, investments, part-time gigs with friends and co-workers?
  • Where do you spend your money?
  • Are you saving any part of that income?
  • What, if any, savings do you have?

This phase of your analysis also involves taking a long hard look at your lifestyle to identify potential areas where you could reduce (or even eliminate!) expenses and put that money aside toward debt repayment. Learn how to create a budget and stick to it.

Doing this analysis should give you a clearer picture of whether you consolidate your debts, you can afford to pay the consolidated balance. You’ll understand how frequently you’ll be able to make payments and the size of each installment you can afford to pay.    

Step 3: Consider Your Financial Future

Given that your primary focus right now is wrestling debt, it might seem counterintuitive to think beyond just getting out of debt, but part of a successful debt consolidation strategy must involve looking to the future. Specifically, ask yourself:

  • What if you had an emergency (accident, medical necessity) tomorrow, do you have a rainy day fund to deal with it?
  • Do you plan to buy a house, or make any other type of major purchase, soon?
  • Are there any planned changes to your personal status — marriage, children, change in jobs, relocation — that might put a strain on your finances?

Debt consolidation is about ensuring a more secure and stress-free financial future. Therefore, looking beyond the present is important if you want to create a successful strategy. For instance, one potential impact that debt consolidation might have is on your credit score.

Any debt consolidation plan will likely involve one or more hard inquiries into your credit history, resulting in a temporary hit to your credit score.

Temporarily, in the immediate aftermath of debt consolidation, new credit might be harder to receive or more expensive to secure.

If you do have an unavoidable expense coming up shortly (like a wedding or expensive medical procedure) for which you may need to take a loan, perhaps you should defer your debt consolidation plans until that situation passes.

Step 4: Learn More about Your Debt Consolidation Options

Now that you know what you owe, what you own and how much you can afford to pay toward any future debt consolidation solution, it’s time to assess which solution (or a combination of them) is right for you.

Here are four debt consolidation options that you can initiate and manage by yourself:

Balance Transfer

If your financial challenges relate to debt obligations that you believe you can quickly address — if only you get some breathing space — then a balance transfer strategy might be best for you.

This option involves applying for a new zero-percent interest credit card and transferring all your other outstanding debt onto this new card. These 0% interest cards come with a limited time offer, after which there may be a steep rise in the interest payable on any outstanding balances.

To make this strategy work, your primary focus must be to pay down all or a significant amount of the principal owed, since you won’t be paying any interest on amounts owed during the no-interest period. Make sure you choose a credit card with the longest no-interest period and the lowest post-no-interest-period rate.

Unsecured Loan

This option involves consolidating multiple debts from several creditors (credit card company, student loan provider, car dealership) and borrowing money from a single lender to pay off the other debts.

For instance, if you owe $5,000 in credit card debt, $7,000 in student loans and $3,000 in car loan payments, you borrow $15,000 from the debt consolidation lender, who repays the other three creditors on your behalf. If you owe several student loans, you may be eligible to tap into the federal government’s direct consolidation loan program as a way to combine and pay off student loans that have higher interest rates.

If you take on a single unsecured loan and eliminate all your other debts, you can focus on repaying that single loan instead of juggling multiple debt obligations each month. To make this strategy work, you must ensure your unsecured loan has an overall interest rate that’s lower than the pooled rate of the debt it replaces.

Home Equity Loan

If you own your home (or have built significant equity in it), you might qualify for a low-interest home equity loan that’s secured against your home.

Use this strategy to borrow enough money to pay off higher-interest debt first so it’s worthwhile to then owe a much lower, fixed interest-bearing home equity loan. For instance, it might make sense to use your 15% interest home equity loan to pay off credit card debt that carries a 20% interest rate.

The risk of using this strategy is that because your home is the collateral that secures the loan, failure to repay it could put your home at risk.

Home Equity Line of Credit (HELOC)

Tapping your home equity in times of declining property values could work against you. If you find yourself in need of funding to help pay off other debts, you might consider a HELOC.

Like a home equity loan, HELOCs tap into the equity built in your home. However, as opposed to a one-time lump-sum payment, HELOCs provide you a revolving sum of money that you can tap into when required. If you borrow $10,000 from a $15,000 HELOC, you’ll only have $5,000 more to borrow from until you repay the $10,000. Then, you’ll have $15,000 to tap into again.

Using a HELOC strategy allows you to borrow from your approved balance to pay down multiple debts. You only pay interest on the amount that you tap into (or borrow). Though HELOCs usually carry a lower interest rate than home equity loans, if not managed well, this variable rate borrowing strategy could harm your debt consolidation efforts in times of rising interest rates.

Step 5: Debt Management Counseling

If your debt situation is extremely complex or you feel that a DIY approach is beyond you, consider seeking professional help. This option involves working with a professional debt counseling service to help you restructure your debt obligations and deal with any new debt that results from the debt management plan.

Your debt counselor will work with you to come up with a debt management plan based on your personal financial situation. He or she will then present the plan to each of your creditors for approval. Upon approval of your plan, you remit a single monthly payment to your counseling service and the counseling service pays your creditors each month.

Before approaching a debt counseling service, make sure you do your research and conduct extensive background checks on several prospective professional organizations. To find out if a debt management service is right for you, work with a credit counselor accredited with organizations such as the National Foundation of Credit Counseling (NFCC) or Financial Counseling Association of America (FCAA).   

Consolidate with Caution

While there may be perfectly valid circumstances for piling on debt in the first place: job loss, divorce, separation or medical bills, debt consolidation is not the silver bullet that by itself gets you out of debt permanently. It’s best when used as a short-term tool until you become debt-free, significantly reduce your reliance on expensive debt or get a handle on your debt challenges.    

Consolidating debt can be a great strategy for managing and ultimately paying off debt that’s grown to discomforting levels. However, because of the peace of mind debt consolidation sometimes offers, it can easily lull you into a false sense of security that tricks you into falling right back into a spiral of debt accumulation.

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