If you have debt from multiple sources like credit cards, car loans, personal loans with different APR, you should look at Debt consolidation as a way to lower your interest rate and simplify your life by replacing all these payment with one payment
Let us take an example to understand how powerful debt consolidation be and how it can help you in paying down debt.
Let us assume Jack has three credit cards with $5,000 balance on each of them. In this example we will assume the APR on these cards is as follows 15%, 18% and 20%. All of them have to be paid back in a period of five years.
For Debt 1, jack has to pay $118.95 per month and a total of $7,136.98 over the life of the loan. $2,136.98 will go towards interest payment.
For Debt 2, jack has to pay $126.97 per month and a total of $7,618.03 over the life of the loan. $2,618.03 will go towards interest payment.
For Debt 3, jack has to pay $132.47 per month and a total of $7,948.17 over the life of the loan. $2,948.17 will go towards interest payment.
Jack will be paying around $378 monthly to pay down these debts over a period of five years and would have paid over $7,700 in interest expenses.
Using Debt consolidation, Jack can reduce both the payment and the time needed to pay back the loan. If you have a good credit score, you can get a personal loan at 7-9% APR from a bank or peer to peer lending sites like Lending Club and Prosper. The difference in the monthly installment can be a huge. If you were able to pay the higher monthly payments, you can maintain your monthly payment and you will be out of debt sooner.
In the first option, after consolidation, Jack has $15,000 debt with 9% APR which can be paid down in 5 years with $311.38 in monthly payments. This will result in a saving of $67 per month for a one time effort. Only $3,682.52 goes towards interest payment.
Under option 2, if jack maintains the same level of payment after reconsolidation, he can pay back the same debt ($15,000) in only 4 years. This one time debt consolidation exercise saved Jack one year of interest payment. Only $2,917.23 goes towards interest payment.
How to make debt consolidation work
Debt consolidation can be tool to pay down debt in the same way using 0% loans from balance transfer offers to pay down debt can be but if you do not use debt consolidation properly, it can bite you back.
The general goal with debt consolidation is to reduce your APR, streamline your payments, and get you on the path of becoming debt free. However there are some things you have to keep in mind when you go for debt consolidation:
Try to keep the duration of the consolidation loan around the same as your current loans. In the above example, if Jack was to opt for option 3, he would save a lot more on a monthly basis but would have to pay the loan for a period of 10 years and would end up paying more towards interest expenses over the life of the loan. While this may be helpful for someone who is struggling to meet the payment on their debt, it will keep you in debt for a longer period of time. This is one trap to avoid when you are going for debt consolidation.
It only makes sense to refinance higher cost debt with lower cost debt not the other way round. For sake of simplicity, sometimes you may be tempted to consolidate all loans you have. This may sound like a wise thing to do but is a financial mistake unless you have a history of missing payments because you cannot manage the different payment you make.
Do you use debt consolidation? How much has debt consolidation saved you?