Debt consolidation can seem like a solution to many of your financial problems. It gives you the scenario of trading in several expensive loans for a single cheaper loan that would allow you to be debt-free sooner. The reality of debt consolidation is less rosy. If done correctly, it can save you money and even raise your credit score. For many people, however, a consolidation loan is just one more debt hanging around their necks.
Debt Consolidation
The basic concept of debt consolidation is simple. Take out one low-interest loan. Use that money to pay off all your small, high-interest loans. Instead of managing lots of bills, you only need to keep track of one. For most people who are in debt, though, a low-interest loan is a pipe dream. Lenders don't offer cheap credit to people with bad credit histories. To get a better deal, people take out home equity loans, using their houses as collateral. Secured loans come with lower interest rates, because the lender isn't taking as much of a risk as with an unsecured loan.
Debt Consolidation and Credit Scores
The biggest factor in determining your credit score is your repayment history. If you've missed payments in the last seven years, it will show on your credit report. Being as little as a day late can hurt your credit score. So if you're the sort of person who has trouble juggling lots of bills, a single loan may be right for you. It's easier to remember to pay one bill a month than a dozen. If a single loan means you won't miss any payments, then consolidating may be for you. However, there are some downsides. Lenders like to see a diverse range of debts, such as credit cards, car loans, mortgages, bank loans and store cards. By consolidating, you may be getting rid of that diversity. Moreover, consolidating can actually increase your overall debt, hurting the crucial debt-to-credit and debt-to-income ratios.
Warning
Even if you're willing to put up your house as collateral, consolidation loans aren't cheap. Watch out for hidden fees and massive charges. Before you sign on the dotted line, be sure that you can keep up with the payments. With a home equity loan, you risk losing your home.
Other Options
There are many reasons people fall into debt. The most common is chronic overspending. Consolidating your debt with a home equity loan will not change your spending habits. The only way to get out of debt is to consistently spend less than you earn. This will also increase your credit score. While they may seem complicated, credit scores are actually pretty simple. They tell potential lenders how creditworthy you are. If you want a higher credit score, you will need to become creditworthy. That means changing the habits that got you into debt in the first place.
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