Pros and Cons of Debt Consolidation

Debt can be anything, but in the financial sense, debt is the amount of money that one person has borrowed from another and not repaid as per the agreement of loaning. A debt contains the principal owed money along with the interest fee if any. 

 

Depending on the geographical location, consumer debt can have different kinds of constituents. In most cases, home debts, car loan debts, and credit card debts form the majority portion of consumer debts. 

 

When different loans burden you, it might seem like a herculean task to overcome that pressure. However, you must take immediate and decisive actions to ameliorate the situation. Failure to do so might result in severe fiscal issues like bankruptcy and insolvency. 

 

Debt consolidation is one such tactical way to handle the weight of different debts incurred by you. In this article, we’ll be discussing some of the key pros and cons of this approach.

What is debt consolidation?

Debt consolidation can be defined as a financial plan employed by an individual, institution, or even nation-states, which lets them pay off many different kinds of outstanding loans at once by taking one large loan.

Advantages and Disadvantages of availing of a debt consolidation loan:

Advantages:

  • Quicker loan settlement:

A debt consolidation loan will ensure swift repayment of all outstanding debts. It is essentially beneficial for those who have accumulated serious credit card debts. 

 

Since credit card debts do not have strictly defined deadlines for payment, people tend to procrastinate, delaying repayment. The fixed payment schemes of debt consolidation loans ensure timely deposits.

 

The longer you delay repayment of debts, you incur the more interest fee. Whereas, if the debts are cleared quickly, it takes off a burden, allowing you to make your next financial plans.

  • Simplification of debt payment:

If you have 3 or 4 different outstanding debts with varying dates for deposit every month, it becomes hectic to tackle all of those, increasing stress on your mind.

 

As the debt consolidation loan is taken to pay off all those different loans, it brings the payment scheme under one umbrella. Now you have one big loan to pay off at a singular designated time each month instead of numerous small loans.

 

This makes monthly budgeting simpler and decreases the risk of missing one payment due to confusion.

  • Interest rates are much lower:

The rate of interest applicable on loans taken depends on several factors like the amount loaned, the borrower’s credit score, and the tenure period agreed on. 

 

Given that all the factors remain the same, you will get much lower interest rates on the debt consolidation loan than the interest paid for the credit card loan you might be nursing. 

 

Currently, interest rates on credit card loans are approximately more than 16% annually, but personal loans interest rates starting average 11% to 22%. A person with a good credit score at the bank may get even lower rates. 

  • A steady and static repayment schedule is created:

Debt consolidation loans come with precise schedules that tell you the exact amount of money to be paid for the month and the exact date it must be paid. 

 

This creates a disciplined system for repayment that ensures timely deposits of money, preventing undefined extension of the tenure, as might happen with credit card loans. Instead of the debt hanging indefinitely over your head, it is paid off within a designated time.

  • The credit score is improved greatly:

The credit score is the marking system by which banks validate a customer’s trustworthiness and reliability. 

 

Taking a debt consolidation loan means going through a rigorous credit inquiry. This will leave a slight negative impact on your credit score. However, it can cause a significant improvement in the score in the long run. 

 

A person’s transaction history makes up roughly 35 % of their credit score. Since taking a debt consolidation loan encourages one to make timely deposits, over time, with each consecutive payment, the credit score will increase remarkably. 

 

Also, if you keep open any credit card on which you had debt before consolidation, you will reap additional benefits on credit utilization ratio as well as improve credit history. 

 

Disadvantages:

  • The debt consolidation loan is not by itself a solution to financial issues:

The debt consolidation loan is a means to manage your finances better and more efficiently. Taking one does not mean bad financial choices in the future will not land you in debt again. The debt itself does not eliminate that possibility. It is also necessary to be pragmatic and plan your budgets wisely so that you may take maximum advantage of the debt consolidation loan scheme.

  • Service charges imposed by banks:

Certain separate fees may be imposed on debt consolidation loans by the banks.

Such as, 

  • Loan origination fees.
  • Balance transfer fees.
  • Closing costs.
  • Annual fees.

 

Therefore it is crucial to carefully go through all the terms and conditions, hidden costs, and other charges that may be applicable before committing to a debt consolidation loan scheme. 

  • Contrary to expectations, the interest rate might be higher:

Several factors control the interest rates applicable to you. One of the principal factors is your credit score at the moment of taking the loan. 

 

Depending on these deciding factors, your interest rate for the debt consolidation loan may turn out to be much greater and even greater than the interest rate you are paying for the already outstanding debts meant to be consolidated.

 

The loan amount and tenure also play key parts in this. If you get a lower monthly payment rate, but the duration of the payment period is much longer, it means that over time you will pay much more than previously planned because of interest. 

 

As such, it is always important to properly weigh and analyze the options available to you. 

  • Failing to meet deadlines can have dire consequences:

On the one hand, debt consolidation brings all of your different debts under one roof, allowing for easy management and some savings down the line. However, if you fail to clear the monthly payments even after availing of the lucrative and manageable plan, there can be many issues. 

 

Firstly, banks can charge a late payment fee for the delay in payment. Besides, if payments are rejected because of inadequate money, there can be a returned payment fee. These will pile on your already heavy financial burden.

 

Secondly, if you are unable to make the payment for a long time after the deadline is reached, the credit bureaus will be notified about it. This will significantly decrease your credit score. What this means is, in the future, if you try to avail any loan, banks will charge higher interest rates.

 

If any is available, it is wise and advisable to enroll in an automatic payment scheme so that no payment is missed, even inadvertently.

Conclusion:

Modern finance requires a very analytical and far-sighted mind to be navigated. It is always prudent not to incur debts in the first place. However, if loaning becomes the only choice, one should always be careful while choosing their options. A debt consolidation loan can be a lucrative prospect, but it is always important to be mindful of the pros and cons, which are detailed in this article.

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