When someone is deep in debt and struggling to find a way to cope, all sorts of remedies are suggested. One of the most common ways of dealing with high interest credit card debts is known as debt consolidation. However, some people may still wonder, “How does debt consolidation work?”
In theory, this is a simple process. What happens is that one takes out another loan for enough cash to pay off all the higher interest debts, usually credit cards. This loan carries a much lower interest rate and allows the borrower to make a single monthly payment that is usually less than half the sum of the credit card payments one was making. This allows the borrower to keep more cash in his/her pocket to take care of immediate needs and expenses and avoid increasing his/her debt.
In practice, it is not quite this simple as a rule. Most people are tempted to go ahead and use their credit cards while paying off the consolidation loan. When this happens, they can end up in worse financial shape that when they started. For this reason, many lenders that offer these loans are now requiring borrowers to take credit counseling courses that teach them how to handle debt more responsibly.
Ideally, one should cancel all credit cards, with the exception of keeping the one with the lowest interest rate for absolute emergency use only. This will help to eliminate temptation.
Obtaining a debt consolidation loan can help boost one’s credit score. This is because the lender reports to the three major credit bureaus each time a payment is made. When all the payments are made on time, the reports are positive, eventually raising one’s score as creditors begin to see one as a safer risk.
Having several credit cards open and using one to pay off another or making minimum payments on several each month can hurt one. This is because, even if the payments are received on time, the balances continue to grow at a steady rate. Part of one’s score is based on the amount of debt he/she has compared to his/her income. Making payments on a single loan lowers the amount of debt each month until it is paid in full.
Some would argue that taking out another loan to pay off existing debt is a bad idea. However, this particular type of loan is specifically designed to help one get control of his/her debts and begin to move forward financially. Unlike credit cards, this debt is normally secured with collateral. Most use the equity in their homes as security for this loan. Studies have shown that most borrowers will work harder to ensure they make all their payments in a timely fashion to satisfy loans where they are at risk of losing something of value such as their home than they will a debt that is unsecured.
The answer to the question, “How does debt consolidation work?” is simple. One combines all his/her high interest debts into a single loan that has a lower interest rate. This results in saving over time as one pays the loan off as well as savings now as one has more cash in hand to take care of immediate needs.
