How Does Debt Consolidation Work, Exactly?

how does debt consolidation work

Are there more than a few bills this month than you saw just a few months ago? You’re certainly not alone. It’s that time of year when home owners start getting their credit card statements and they soon realize they probably spent more than they had planned over the holidays. But pay they must and many do so by taking out a debt consolidation loan. How does a debt consolidation loan work?

A debt consolidation is the process of taking out one larger loan to pay off several higher interest loans. Instead of a couple of credit cards and a department store card, consumers can elect to take out a debt consolidation loan. This makes sense when the consolidation loan carries lower rates and more favorable terms compared to other consumer debt. 

How Does Debt Consolidation Work?

A consumer applies for a single loan to cover all or part of their outstanding credit card balances, automobile loans and other installment debt. Instead of several, separate monthly payments the debt consolidation loan pays off all the outstanding balances leaving just one lower monthly payment. There are unsecured and secured credit card accounts. An unsecured debt consolidation loan is issued without any collateral used as security. A secured account is one that has a lien filed against an appraisable asset the consumer owns. As you might imagine, both types of consolidation loans have lower rates than what might appear with a credit card account. But the secured loan will have an even lower rate compared to an unsecured loan. And the lowest secured rates are those reserved when real estate is the asset collateralized.

How Can a Debt Consolidation Lower Your Interest Rate?

how does debt consolidation work

For example, a consumer has two credit cards both with a variable interest rate. Because rates have been on a gradual increase over the past year and a half, the monthly payments keep going up. The consumer also has an automobile loan with a rate of 6.00 percent and a private student loan. Each account carries an interest rate that is higher than what is available with a real estate loan. Instead of paying interest on a credit card that has a 10 percent rate, homeowners can choose to refinance to a lower rate while paying off higher interest debt. The consumer applies for a mortgage, pays off the outstanding balance and closing fees and pulls out additional funds to pay off the two credit cards, car loan and student loan. The best consumer borrowing rates available today are those reserved for home loans.

How Does Debt Consolidation Help Your Credit Score?

And guess what else happens when outstanding consumer debt is paid down or eliminated? Credit scores can also improve. One of the two most important factors when calculating someone’s credit score is the payment history and available credit. When someone pays their bills on time but also has credit card balances of say $8,000 on a $9,000 credit line, credit scores will be slow to improve because the credit card balances are approaching credit lines. By taking out a debt consolidation mortgage, not only can someone lower their interest rate or switch from a variable rate loan to a fixed, they can also pay down their credit balances. Credit scores improve when balances are kept below one-third of their credit line.

That’s the double bonus here. A homeowner can lower their overall monthly payments by refinancing their current loan and paying off high interest debt but also improve their overall credit profile by paying down credit card debt with a low interest mortgage program. Note, this financial strategy doesn’t work if the credit card balances are paid down and then those same accounts are charged right back up again. In this situation, the homeowners put themselves in a worse position than they were before. But when properly used, getting a debt consolidation mortgage can be an ideal way to pay off high interest credit cards and other consumer debt while lowering monthly payments. Perhaps more important than asking "How Does Debt Consolidation Work?", you can see the benefits for yourself by clicking the link below.

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