Debt consolidation is a useful tool in every budgeter’s tool belt. It can lift heavy debt loads off your shoulders, open doors to financial freedom and shine a light on an otherwise darkened future plan. In this article, we’ll show you five easy steps to renovate your debt load with this multifaceted tool.
Getting Out of the Red
Consolidation is one way to rid yourself of your debts quickly by combining all your current outstanding loans and liabilities – and their generally outrageous interest rates – into a single debt vehicle with a lower interest rate. Instead of having to pay a number of different lenders each pay period, you take out a new loan to pay off all of the other liabilities and are left with only one, lower interest loan to service, allowing you to pay down your debt more quickly.
Consolidation is a way to save “bags of money,” according to Gail Vaz-Oxlade, the personal finance guru formerly behind TV’s “‘Til Debt Do Us Part.”
“Consolidation is important because people are often paying too much interest on their debt,” Vaz-Oxlade said. It’s also important for people who don’t know, or can’t seem to manage to pay their bills on time, she added. During her many years of working with couples and their finances (on and off the show) Vaz-Oxlade said she has run into a lot of individuals who are too scared to open their statements and who are overwhelmed by multiple payment dates. A consolidation loan takes all the outstanding debts and payments and transfers them all into one loan with only one payment date to remember and one statement to read.
How it Works
Taking on debt to get rid of debt? How can this possibly help? Let’s look at an example.
Example – Consolidation Savings
Let’s say that you currently have three credit cards that charge 28% interest annually, they are maxed out at $5,000 each and you’re spending $250 a month on each card to pay them off. If you were to pay off each credit card separately, you would be spending $750/month for 28 months and you would end up paying a total of around $5,441.73 in interest.
However, if you transfer the balances of those three cards into one consolidated loan at a more reasonable 12% interest rate and you continue to repay the loan with the same $750 a month, you\’ll pay roughly one-third of the interest ($1,820.22), and you will be able to pay off your loan five months earlier. This amounts to a total savings of $7,371.52 ($3,750 for payments and $3,621.52 in interest). Remember, however, that consolidation only works if you don’t pick up those three credit cards at the end of the day and start spending again. Consolidation is a tool to help you get out of the doghouse, not to get you a nicer and more expensive doghouse.
Should You Consolidate?
First, let’s take a look at your current debt load and spending habits to determine whether consolidation is right for you. Vaz-Oxlade offered a list of questions that demand you be honest with your finances and yourself.
5 Steps to Easy Consolidation
Step 1: Identify Your Debt Load
This is where you have to face those unopened statements and bills. You need to determine good debt from bad. For example, mortgage debt that is less than 25% of your gross income is considered good debt, whereas consumer debt is bad debt.
Next, calculate total debt owed to family and creditors, identify which debt has the highest interest rates and find out how much you are actually paying in interest on those debts.
As shown in the above example, three credit cards maxed out at $5,000 and paid off over two years actually cost $20,441.73 to pay off – significantly more than the $15,000 owed. So find out what you’re actually spending your money on and determine how much you need to pay it all off.
Despite how bleak this amount may seem, bankruptcy is rarely the only choice for people in financial distress, and for many, servicing the debt might be a better option.
Step 2: Create Your Budget
Decide how much you actually need for daily life, fun, savings and debt repayments.
You will probably find out that you’ll have to cut out some of the luxury items in your budget until you get your debts in order.
Step 3: Get your consolidation loan
How to Apply
Call and book an appointment with a financial advisor at your bank of choice. Often, you will get the best rates with the bank you have the most history with or the one that holds your mortgage.
Although each lender will probably require different documentation depending on your history, the most commonly required pieces of information include a letter of employment, two months’ worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.
Equity vs. Debt
“If you have debt and equity, you should refinance,” Vaz-Oxlade said.
This means that you take your unsecured debt (from credit cards or personal loans) and put that debt into a secured debt structure (like your mortgage). Banks will often charge you less interest on a secured debt because if you default, the bank can get its money back (through the sale of your home or other assets).
Vaz-Oxlade recommends that you take no longer than three years to pay off your debt to avoid debt fatigue.
Step 4: Pay Off Your Debt
This may be decided by your lender, who may choose which debt gets paid off first.
If not, you should start by paying off your highest-interest debt first. If you have a lower-interest loan that is causing you more emotional and mental stress than the higher interest ones (like a personal loan that has stretched family relations), you may want to start with that one instead.
If you aren’t given the final say on which loans get paid off first and one of them is important to you, you should still fight for it to be paid off in a timely manner.
Step 5: Stick to the Plan
Consolidation only works to free you from debt if you stop overspending once you pay off your cards. Once you pay off one set of debts, move the payments to the next set in a waterfall payment process until all of your bills are paid off. Once you are debt free, you can move those payments into savings or investments.