What is Debt Consolidation?

Debt Consolidation Explained

Even people who strive to honor their debt obligations can find themselves struggling to keep up with the payments. At times, this situation arises due to unexpected expenses or possibly a cutback at work. Whatever the underlying cause, it is important to understand that there are ways to reorganize existing debt into a form that is easier to manage. That is where the concept of debt consolidation comes into play.

Understanding the Basics of Consolidating Debt

This process involves finding a way to bundle or consolidate a number of unsecured debts one single debt. The most common approach is to work with a lender who is willing to extend a loan that is sufficient to settle all the other debts, leaving the debtor with a single obligation to manage on a monthly basis.

With this approach, the debtor usually frees up a significant portion of his or her income, and may even lock in a more competitive rate of interest on that consolidation loan. When the latter is the case, this will mean that the debtor actually pays less in interest over the amount of time it takes to settle the loan in full.

Finding a Lender

When using consolidation as the means of restructuring debt, it is important to compare the offerings of different lenders. Even if the debtor’s credit score is not the best right now, there are lenders who are willing to take a chance. This is especially true if the debtor has an asset that can be used to secure the loan.

Even if there is no collateral to use to the loan, debtors should realize that there are lenders out there who are willing to help. This is especially true if the debtor has managed to continue making payments on those individual debts on time. Keep in mind unsecured loans may carry a slightly higher rate of interest, since the lender is taking on more risk by approving the loan application. Even allowing for that higher interest rate, there is still a good chance that it will be lower than the average rate that applies to all of those individual debts.

Settling Individual Debts

Many lenders who extend debt consolidation loans also oversee the process of settling those individual debts. A common practice is for the debtor to supply a list of outstanding creditors, the account numbers, and the contact information related to each debt. The lender contacts each one and makes arrangements to either send a check through the post to pay off the accounts in full, or prepares electronic fund transfers that each creditor applies to the accounts. When it is all said and done, those debts are paid in full, and the debtor is left with the monthly loan payment to manage.

Protecting the Credit Rating

Choosing this approach is good for the credit rating in more than one way. By securing a loan that makes it possible to retire all those other debts, the debtor will create a number of positive comments on his or her credit reports. Those zero balances on those accounts will indicate to future lenders that the individual does proactively take steps to manage debt efficiently. Even with the presence of the one consolidation loan on the credit report, many lenders will be willing to extend financing for important purchases such as a car or even a home.

Paying Off the Loan

The nice thing about a debt consolidation loan is that the debtor is free to make additional payments when and as possible. Doing so will have the effect of paying off the loan before it actually comes due. Choosing this course of action will produce two benefits that the debtor will find helpful in the future.

Since lenders do report to at least one of the three major credit reporting agencies, being ahead in the payments will certainly look good on those reports. It also helps to create a more favorable debt to income ratio, which will help increase the credit score. In addition, making extra payments will also reduce the amount of interest that the debtor pays over the life of the loan.

Avoiding the Accumulation of More Unsecured Debt

In order to get the most benefit from debt consolidation, the debtor must refrain from accumulating more debt. This means that those now settled credit card accounts should not be used for anything other than emergency situations. Even then, those balances should be retired as quickly as possible. Using this approach will position the debtor so that obtaining financing for a vehicle or even a first house will be much easier.

While debt consolidation is not the answer for everyone, it is worth considering. Used properly, it will ease financial stress, and ensure that lenders see the debtor as being credit worthy.