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Understanding debt consolidation


 Debt consolidation is one option to help you pay off debt. However, it may not always be the best option for your financial situation. Debt consolidation involves combining several loans into one by taking out a new loan to pay off existing debt. There are several ways to consolidate debt, each with their own special issues.

 Credit card balance transfers allow you to transfer the balance of one credit card to another credit card. This option could be helpful if you transfer the balance of a high-interest credit card to a card with a lower interest rate. Be cautious of promotional interest rates for balance transfers. These rates may be low at first, but after a short period of time they could rise higher than what you had before transferring balances. Balance transfers usually come with extra fees, such as a set percentage of the amount of money you are transferring. When considering this option, think of the reason for your credit card debt. Is the debt from a one-time emergency, or because of overspending? If the answer is overspending, a balance transfer may not be wise. Unless you plan to cut spending or change spending habits, a balance transfer could end up increasing your debt if you continue to spend on the original card.

 Debt consolidation loans are specifically intended to combine your debts into one payment. This could help if you struggle to keep track of several payments such as individual student loans or credit cards. While it might be easier to have one payment, these loans also may cost you money in the long run from added fees, climbing interest rates, and longer-term loans. Interest rates and monthly payments may seem lower than your existing loans but may only be low for a short period of time. If you choose this option, create a plan to aggressively pay down your debt before the new interest rate kicks in.

 Home equity loans allow you to borrow against the value of your home. Home equity is the difference in money between the value of your home and how much you owe on your mortgage. A home equity loan allows you to borrow some of this difference and use it for other things, including paying off debt. These loans often have a lower interest rate. But your house is at risk of foreclosure if you do not pay the loan back on time. You also might have to pay closing costs on the loan, or face being “upside down” on your home if you choose to sell. Tapping into home equity is best saved for emergency situations or completing work on the home.

 When thinking about debt consolidation, always compare monthly payments, interest rates, associated fees, and long-term costs of the new loan. Debt consolidation may not be the best option, if you don’t address your financial situation or spending behaviors. If you have debt, look at your budget and spending habits. Also, contact the creditors of your existing loans. They may be able to change your payment due dates, lower your monthly payments, or reduce your interest rates to help you pay off your debt.


Sources: Nichole Huff, Ph.D., Assistant Extension Professor, Family Finance and Resource Management; Miranda Bejda, doctoral student, Family Sciences

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