Understanding the Concept of Debt Consolidation

With the accumulation of different types of debt, you might face a financial crisis. In such a situation, the best option would be to consolidate your debt. Simply put, debt consolidation refers to taking a new loan for paying off all the other debts. Under this concept, multiple debts are combined into one larger debt. It is usually offered by a bank or any other financial institution in the form of a loan. 

Such loans have a lower rate of interest and more favourable repayment terms. A debt consolidation loan can be an effective tool in dealing with credit card debt, personal loans, and other liabilities. Most individuals apply for such loans through credit unions or banks. Applications are usually approved if you have a good relationship and payment history with the financial institution.

Major types of debt consolidation loans

Generally, there are two types of debt consolidation loans. They have secured loans and unsecured loans. Secured loans are the ones that are backed by one of the assets owned by the borrower. This can be a house or a car, which works as collateral for the amount borrowed. On the other hand, unsecured loans are the ones that are not backed by any assets. 

Such loans usually have higher rates of interest and are of a lower amount. There are differences in the interest rates charged in both these types of loans. However, they’re still lower than the interest rates charged on credit cards. The rates are fixed in most cases, which means they do not vary over the period of repayment.

Other ways of consolidating debt

Besides secured and unsecured debt consolidation loans, there are other ways of consolidating debt. One of them is to get a new credit card. It would be a lot more beneficial if this new card charges little or no interest for a specific period. Using this credit card, you can consolidate all your credit card payments into this new card. Your home equity loan or home equity line of credit can also be used for debt consolidation. 

Individuals with student loans can also benefit from certain consolidation options provided by the federal government. This is known as the Federal Direct Loan Program. The new interest rate in this case would be the weighted average of the earlier debts. It must be noted that private loans won’t qualify for this program.

Debt consolidation requirements

In order to qualify for debt consolidation, you need to have sufficient income and creditworthiness. This is especially true if you’re approaching a new lender. The types of documentation required would depend upon your credit history. The documentation required includes a letter of employment and two months’ statements of existing credit cards or loans. 

You might also require letters from creditors or repayment agencies. Upon getting your debt consolidation plan, you must consider whom to pay off first. In most cases, this is decided by your lender.

Effect on your credit score

A debt consolidation loan might enhance your credit score in the long run. You can keep interest payments low by paying off the principal portion of the loan sooner. A boost in your credit score would bring you certain benefits. It would also make it easier for you to get a loan or credit card in the future.

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