How Does Debt Consolidation Work?

Overview

• What is debt consolidation?
• Debt consolidation process
• Alternatives to a debt consolidation loan
• Is debt consolidation a good idea?

Debt consolidation combines multiple cash loans and debts into a single loan. This means that you have only one repayment each pay cycle. This can make it easier to manage debts and plan your budget.
Having a single debt consolidation loan rather than multiple loans may help you to manage your finances better. You might be less likely to miss a repayment with only one repayment rather than several. Missed loan payments can negatively impact your credit score, so a debt consolidation strategy can help you manage your credit rating.

In some instances, consolidating consumer debt into a single loan will mean lower interest and the ability to repay the total amount of debt more quickly. However, be sure to read the lender’s terms and conditions to ensure that you will ultimately be better off financially. Consider:

• The interest rate of the debt consolidation loan
• The loan repayment term — a longer loan term can lead to the total cost of the debt being higher
• The ability to make additional repayments to reduce the debt more quickly.

If you’re looking to consolidate your existing debt, follow these steps.

1. Assessment

Evaluate your current debts, including credit card balances, personal loans, or other outstanding obligations like Buy Now Pay Later accounts.

2. Research and comparison

Research and compare consolidation loan options from various lenders, such as banks, credit unions, and online lenders. Look for favourable interest rates, fees, and repayment terms. If you secure a lower interest rate or a shorter loan term on the consolidation loan compared to your previous debts, you may save money over time.

3. Application

Apply for a loan with the chosen lender. The lender will assess your creditworthiness, income and employment status, whether you can provide security for the loan and other factors to determine if you qualify for the loan.

4. Loan approval

If approved, you receive a loan with a fixed amount that covers the total of your existing debts.

5. Repayment

Use the consolidation loan to pay off your existing debts. Now, you have only one loan payment to focus on. Make regular payments to repay the consolidation loan. This payment is often lower than the combined payments of your previous debts, making it more manageable.

6. Financial discipline

Debt consolidation requires discipline to avoid taking on new debts while paying off the consolidated loan.

Personal loan

A consolidation loan is specifically used to combine multiple existing debts into one loan. A personal loan, on the other hand, is a more general type of loan that you can use for various purposes, including consolidating debt, going on holiday, car repairs or other emergency expenses, without the requirement to merge existing debts.

Credit card balance transfer

A balance transfer is when you move existing credit card balances to a new card with a low or 0% introductory interest rate.

If your credit score is good, you might be eligible for a balance transfer credit card with a low or 0% introductory interest rate. You can transfer high-interest consumer debt onto this card and work to pay it off during the promotional period.

In general, though, if you have multiple types of debts beyond credit cards, a debt consolidation loan might be more suitable. However, if you have significant credit card debt, a balance transfer could provide short-term interest savings.

Debt snowball/debt avalanche

With the debt snowball method, you focus on paying off the smallest debts first, while with the debt avalanche method, you prioritise debts with the highest interest rates. As you pay off each debt, you use the money you were paying toward it to tackle the next debt.

If you prefer a structured approach and want to address multiple types of debts, consolidation could be a good fit. If you want a motivational strategy and have debts with varying balances, the snowball method might suit you.

Home loan debt consolidation

Some home loan lenders will allow mortgage holders to consolidate debt into a home loan, as long as there is sufficient equity available. This will typically mean paying a lower interest rate on the debt, it’s worth noting that the loan term is much longer than other loan types, so this can be a lot more expensive in the long run.

If you do choose this debt consolidation pathway, aim to make extra repayments on the mortgage to take advantage of the lower interest rate to still have the additional loan amount paid down within a few years or even a year.

Whether or not debt consolidation, as opposed to another method of debt management, is a good or bad idea for you will depend on your particular circumstances.

Carefully consider the risks and benefits of each approach before making a decision. You can contact the team at Red Tree Finance for more information, or apply for a small online loan if you’d like to give consolidation a go.

Is it a good idea to consolidate debt?

Debt consolidation can be a good idea depending on your financial situation. If consolidating your debts will increase your costs then it may not be a good idea. However, if consolidating your debts reduces your repayments then it may be a good idea.

Does debt consolidation hurt your credit?

It all depends on which approach you take. Multiple credit inquiries and credit history lengths can hurt your credit score. However, consolidating your debt into a single monthly payment with a lower interest rate could minimise the chance of missed payments and improve your credit score over time.

How does a debt consolidation loan work?

A debt consolidation loan combines your existing debts into one loan. This can be an advantage if you have debts with higher interest rates but combining them reduces your overall interest rate.

For example, if your loans had a combined average interest rate of 50% but consolidating your debts brought them down to 47% then it would reduce the amount of interest you would repay.

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