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What is debt consolidation? Complete guide with pros and cons

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Millions of Americans make mistakes with their finances every year. Some may incur unforeseen expenses that lead them to borrow, and others may extend their credit too much. Whatever the reason, these individuals end up trapped in a spiral of debt that leaves them on the verge of bankruptcy.

That debt collectors call you at home or work is both intimidating and embarrassing. When your finances go wrong, you can receive dozens of calls each month from collection agencies that are looking for money. This scenario is frustrating and affects your mental health.

Debt consolidation is one of the options available to people in debt with multiple creditors. With debt consolidation, you transfer all your outstanding credit in a single loan with a single convenient monthly payment. While this sounds like a fantastic way to sort your finances, it has its drawbacks and benefits.

Let's analyze the pros and cons of debt consolidation to see if it is the right financial decision for you.

The debt situation in the United States

Consumer debt in the United States is beginning to reach problematic levels. As of the first quarter of 2019, analysts measured total consumer debt at $ 14 billion. This figure exceeded $ 13 billion of consumer debt at the peak of the previous market in 2008. We all know how that ended for the economy and the American people.

The great financial crisis of 2008 caused a wave of defaults that compromised the values ​​that subscribed the loans, which caused the greatest financial calamity in history. The crisis affected world markets, and the aftershocks continued for many years later.

Analysts also measure the per capita rate of consumer debt. In 2008, the average American represented $ 41.68 of the total of $ 13 trillion. Today, that figure is $ 44.77, exceeding the proportion in 2008.

Statistics show that Americans are drowning in debt, with no hope of relief in the future. A period of rising life costs and stagnant wages led to the development of an economic condition known as "stagflation." Stagflation occurs when the cost of food, gas, rent and public services increases, but wages remain the same.

Therefore, it is not surprising to see that Americans are struggling to manage their finances. When the money runs out and we still have bills to pay, it is easy to use a loan to get help. Unfortunately, it is a vicious circle where Americans lend money to pay expenses and lifestyle bills, and settle it with their paycheck, just to repeat the cycle.

Finally, interest payments and the increase in the cost of living have an impact on people's financial situation. As a result, they discover that they can no longer pay their creditors, and then they must resort to bankruptcy to get out of the situation and start over.

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Debt Consolidation Explained

When consumers are in financial trouble, a debt consolidation loan can help them resume their affairs. With a debt consolidation loan, you transfer all your existing loans to a new facility.

The lender that opens your account provides you with the funds you need to settle your other outstanding accounts. This transaction leaves you with only one payment to worry about at the end of the month. A single installment is easier to manage and prevents your creditors from paying arrears or late payments on credit bureaus.

Receiving a state of non-payment or slow payment with credit bureaus damages your credit score. By including all your credit lines in a single account, you stop the reporting cycle and keep your credit score intact.

What is the difference between secured and unsecured loans?

Lenders offer debt consolidation loans as unsecured or secured lines of credit. With an unsecured loan, the lender does not require any collateral to finance the agreement. They open an account, provide you with the funds you need to liquidate your creditors and then wait for your monthly payments.

If you do not meet an unsecured loan, the bank will still look for it for settlement, or they could arrange to refinance the outstanding amount. Unsecured loans are preferable for the consumer market because there is less risk to the consumer in the loan. However, banks prefer secured loans where they can defer the risk of the assets they can settle if they do not pay their fees.

Secured loans are different from unsecured loans because the bank requires a guarantee to lend you the money. The lender can secure the value of the loan for your home or other assets that can be liquidated if you do not meet the payments. Secured loans have more risk for the consumer because the bank has direct access to the foreclosure of the asset that provides the collateral in the agreement.

With unsecured loans, you can expect to get a higher APR. The annual percentage rate (APR) is the annual percentage interest rate charged on your outstanding credit line. Since the bank takes more risks with an unsecured agreement, they often offer these loans at a higher interest rate than the guaranteed facilities.

Payment Review

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Use of secured loans for debt consolidation

There are many options to consolidate your debt through a secured loan. The most obvious place to start is to look at the assets you own with equity. Your home is an excellent option to help consolidate your debt. If you have money immobilized on your real estate property, you can refinance it and pay your creditors. You could also take a line of credit on the net value of the home.

Other assets that you can use to finance a debt consolidation loan are car loans with your car as collateral in the agreement. Many lenders will also provide you with a loan against your 401 (k) or your permanent life insurance policy.

Secured loans for debt consolidation professionals

The most significant advantage of using a secured loan is the lower interest payment. When the bank reduces your risk in the agreement, you are offered a lower annual percentage rate. When you receive a lower interest rate, the cost of the loan is lower, which helps you pay off your debt faster.

In some cases, interest payments are tax deductible, but you should check with your accountant before confirming that this is the case. Since secured loans carry less risk for the lender, they are willing to reduce the interest rate.

Secured loans for debt consolidation Cons

The consolidation of your debt through a guaranteed service places the underlying assets in the agreement at risk of seizure by the lender, in case of default. If you do not fulfill your contractual obligations with the lender, you have the right to close the credit line and liquidate the underlying asset.

As a result of experiencing a default, you run the risk of losing the asset. The lender can run your home, liquidate your insurance policies or garnish your retirement account to pay the outstanding amount.

Some assets such as life insurance and 401 (k) plans may not be available to you while paying the loan. If you are using your home to refinance, then the term of the agreement may be much longer than the outstanding debts you currently have. As a result, you end up paying more interest on monthly installments than with a short-term line of credit.

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Use of unsecured loans for debt consolidation

Unsecured loans were common twenty years ago. However, the beginning of the explosion of the 2000 technology bubble, and the Great Financial Crisis of 2008, made the banks more cautious. Today, if you want to get an unsecured loan, you need good to excellent credit to receive financing.

Unsecured loans carry more risks for the lender. Therefore, you can expect to pay a higher annual percentage rate for the privilege of not compromising any guarantee in the agreement. However, although there is no guarantee in the loan, do not confuse it with free money. The bank can still choose to follow its assets and liquidate them to pay off its debt in case of default.

Unsecured loans for debt consolidation professionals

The most significant benefit of using an unsecured loan to consolidate your debt is that none of your assets are at immediate risk of settlement if you fail to meet your loan payments. By using an unsecured loan, the bank assumes most of the risk. It is for this reason that lenders only offer unsecured loans to clients with good credit scores.

Given that you have financial problems, your credit score is probably low. As a result, you may find it difficult to find a lender willing to issue you an unsecured loan.

Unsecured loans for debt consolidation Cons

With unsecured loans, the bank assumes a significant part of the risk in the agreement. As a result, the lender will probably want to mitigate this risk by establishing the loan at a higher annual percentage rate. You will end up paying more interest charges than you would pay with a secured debt consolidation loan.

Personal loan companies:

Debt consolidation or debt settlement?

Consolidating your debt means that you transfer all your outstanding loans into a single loan. With debt settlement strategies, you employ the services of a debt advisor. The advisor negotiates with your creditors a lower settlement amount than you owe.

Most creditors are willing to negotiate if they think there is a risk of default on their payments. However, it is important to keep in mind that you must pay the debt advisor for your services. These costs add up to your debt levels.

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Debt Management Planning

Debt counselors also sit with you and prepare a budget that can pay off your current debt. They can help you evaluate areas of your budget that are costing you money and then allocate those savings to pay off your debt.

Facilitated debt management

The debt management services provided offer the budget services of the debt advisors. The service also allows you to send them money so they can pay their debts for you. By adopting this strategy, the counselor controls his debt management issues.

The services provided ensure that you do not make late payments to creditors. A late payment and you could lose the negotiated interest rate of your outstanding debt, increasing your monthly payments. By adhering to a debt management plan, you can get out of debt faster.

However, it is important to keep in mind that debt facilitators also charge for their services. In most cases, the savings that the facilitator makes in your interest rate and any amount you owe are sufficient to cover the facilitator's fees.

File for bankruptcy

Filing for bankruptcy is a scary thought for Americans. However, in some cases, it is the only option available. Most courts will do their best to avoid allowing you to submit a request. If you are trying to file for bankruptcy to avoid child support, alimony payments or student loans, then consider the court ruling unfair.

These types of debt do not dissolve after filing for bankruptcy, and creditors can still hold you responsible for the money you owe.

How to declare bankruptcy

Read: Bankruptcy explained: how to declare bankruptcy

The final thought: are there other strategies to help you get out of debt?

Debt consolidation is a strategy to get you out of financial matters. However, there are other options to help you get out of this pickle. Instead of going to the bank to ask for a loan, try to see if you have family members who can help you. If you do not have a mortgage and your parents do, try refinancing to take advantage of the low annual percentage rate of mortgage loans.

Look at your lifestyle and examine the areas where you can reduce your expenses. The savings you make every month will help you find the money to meet your financial obligations. Getting a second job to increase your income is also a valid option. By increasing your income, your debt / income ratio improves, and you can afford to pay your creditors.

Whichever strategy you choose to pay off your debt, make sure it suits your earning potential and your lifestyle.

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Disclaimer: The opinions expressed herein are only those of the author, not those of any bank or credit card issuer and have not been reviewed, approved or endorsed by any of these entities.

Disclaimer: The answers below are not provided or commissioned by the bank advertiser. The responses have not been reviewed, approved or supported by the bank advertiser. It is not the responsibility of the bank advertiser to ensure that all publications and / or questions are answered.

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