According to the Federal Reserve Bank of Philadelphia, consumers held a whopping $2.7 trillion in debt as of the second half of 2012. Within that, the average household with credit card debt owes nearly $16,000, according to CreditCards.com. Additionally, the average credit card holder owned 3.5 cards as of 2008, as notes the Federal Reserve Bank of Boston.
The debt picture is bleak in the United States. Plenty of citizens are knee-deep in debt, often from multiple sources. With that comes confusion over paying multiple creditors at various interest rates, which can lead to a messy financial situation.
One option for those in debt is a debt consolidation loan. With this option, you’d take out a single loan to replace multiple bills. So, if you’re currently behind on 4 credit cards, you could combine them into one payment to reduce hassle and have a single interest rate.
Are debt consolidation loans a good idea for you? Let’s explore the potential advantages and disadvantages you would face.
Lower Interest Rate
Debt consolidation loans often come with a lower interest rate than the debt they replace. So, if the average interest rate on your other debt is 20 percent, you may be able to slim it down to 15 percent, for example.
A lower interest rate is not a guarantee, so it pays to shop around. Verify that your rate will be lower than your current average before sealing the deal.
Nobody likes managing bills – at least if they’re not getting paid an accountant’s salary. As such, you can simplify your financial life with a debt consolidation loan.
As mentioned, your narrow down your current debt payments to one bill. Thus, instead of dealing with potential cash flow issues due to varying amounts and due dates, you’ll have one monthly payment to focus on.
For some borrowers, debt consolidations loans are difficult to obtain. This is especially true for those with a high debt-to-income ratio, or the percentage of their income that is used to pay debt.
Think about this from a lender’s perspective. If you walk in an have a relatively small amount of debt and a high income, chances are good you’ll be able to pay your loan on schedule.
On the other hand, if your current monthly debt payments total $1,500 and you bring home $2,500 a month, you’re in a very tight financial situation. Accordingly, most lenders would decline to do business with you.
All debt involves risk. However, with a debt consolidation loan, you’ll often be required to risk a valuable asset as collateral.
To illustrate the extra risk, suppose you have $15,000 in credit card debt. As most credit cards are unsecured, there is little the issuer can do to collect payment if you default.
However, with a collateralized debt consolidation loan, you could lose the relevant asset if you cannot repay your loan. Thus, you may want to think twice before using your house or another important asset as collateral.
Are Debt Consolidation Loans a Good Idea?
Deciding whether or not to pursue a debt consolidation loan is a personal decision that should be based on numerous factors.
If you have trouble managing multiple debts and are dissatisfied with your current interest rates, this is a worthwhile move. However, if you have a high debt-to-income ratio or are concerned you could lose an important asset, reconsider your options. It may pay to test the waters and see what kind of rate you can get to help make your decision, as well.
In general, debt consolidation loans are a good idea – as long as you can lower your interest rate and have a backup plan if you lose your collateral.